SECURITIES REGULATION

I. Common Law Remediesa. Tort of Deceit (Fraud)

i. false representationii. of a material fact

iii. known to be untrueiv. made for purpose of deceivng plaintiffv. upon which plaintiff justifiably relied

vi. from which plaintiff suffered damages as a consequenceb. Equitable remedy of Recission

i. misrepresentation of a material factii. on which buyer relied

iii. in a transaction buyer never ratifiedII. Mandatory Disclosure

a. Pro-mandatory disclosure argument: provides more information to the markets, omissions wont be covered otherwise, instills more confidence in capital markets

b. Anti: disclosure is costly; market should demand the optimal amount of disclosure anyway

c. Event studies look at amendments to 33 Act disclosure obligationsi. Problems: when do you begin measuring impact: passage? Enforcement?

ii. Resulted in abnormal excess returns mandatory disclosure is good!?1. but could be for other reasons

iii. international study (schleifer): increased disclosure led to increased size of financial markets, more liquidity etc

1. these markets might demand more disclosure – causality could be reversed!

III. IPO Allocation and Pricinga. Standard IPO Process

i. Lead Underwriter & Selling Group (allotment)1. Gets firms together to sell2. Allocates securities to members in group3. Establishes offering price shortly before sale through “bookbuilding”

(v. bought deals, which are done quickly)4. Performs price maintenance after sale5. Purchases by underwriter6. Anti-flipping clauses7. Insider lock-ups

ii. Underwriting - Basic Structure1. Methods

a. “firm commitment” - firm purchases securities from issuer to sell to public at agreed upon offering price

b. underwriting syndicate (firm) - including agreement with issuer and between underwriters.

c. “gross spread” = difference between issuer price and public offering price (3 parts) - usually 7%

d. Competitive process because underwriters risk in firm commitment (slow sale and inability to sell tie up capital, affect reputations)

2. “best efforts” - broker-dealers agree for fee to use best efforts to sell securities at agreed price

a. “straight” = any securities sold closes dealb. “mini/maxi” = minimum amount must be sold for deal to close

(proceeds in escrow)c. “all or none” = all must be sold for closed. EA Rule 15c2-4: not allowed to close out an offering before

satisfying stated conditionsiii. Agreement among the Underwriters :

1. Notice to underwriters:a. Number of shares, b. Time at which attorney power can be revoked, Compensationc. Allotment of shares to each underwriter. Important for (1)

compensation, (2) liability limitation (by # of shares)d. The “shoe” = Overallotments. Important because of (1)

Sometimes there are more shares than anticipated, the option to purchase more shares is “green shoe” option, (2) stabilizing = manager buys back some shares in aftermarket (this number is limited by NASD)

e. Anti-flipping Clause. Penalty for members whose shares flip.iv. Agreement between Underwriters and Issuer

1. Price to be paid2. Identification of syndicate members3. Clause mandating disclosure to security holders

v. To protect underwriters:1. Insider Lock-ups. Managers cannot sell shares for 180 days after IPO2. Market Out Change. Clause permitting underwriters out if (1)

restrictions on trading of securities, (2) war, (3) material adverse change in markets, (4) material adverse affect to issuer. NOT good form to exercise this clause

3. Indemnification Clause. Underwriters are not liable for error in registration/prospectus.

4. Contribution Clause. Liability ~ fault.5. Comfort Letter. From issuer to underwriter certifying truthfulness of

information = way for underwriters to get out of liability (fraud, etc.)b. IPO issues

i. Why are IPOs underpriced in the short term ? - avg. price increase of 18.8% during 1st day.

1. Firms are risk-averse 2. Advantages in aftermarket (post-initial)3. Avoidance of liability for overpricing4. “Spinning” - selling to other companies about to go public to flip in

order to build relationship

ii. Should IPOs be sold at one fixed price ?1. SEC requires price in prospectus2. NASD has anti-discounting rule

iii. Ways to circumvent:1. Designated Order Technique - offering free research, etc. for overall

discount2. Overtrade/Swap - exchange of securities buyer already owns that are

worth less3. Recapture - institution forms a broker-dealer subsidiary and buys stock

at a discount, then turns the stock over to parent institution (= overall discount).

iv. Do December 2004 Proposed IPO Rules (NYSE, NASD, SEC) make sense?1. Major concerns: IPO underpricing allows underwriters and managers

to benefit at expense of issuers2. Prohibits allocation of IPO stock to:3. Customers (mutual funds) as quid pro quo for excessive commissions4. Customers (future issuers) as quid pro quo for future business5. Customers (brokerage clients) as quid pro quo for buying future “cold”

issues 6. Officers/directors of existing or prospective ibanking clients -

“spinning”7. Particular individuals selected by underwriters8. No commissions on flipped shares unless anti-flipping penalties

uniformly assessed/enforced9. Requires extensive disclosure to issuers about allocations of issue10. Restrictions on “laddering” - requiring purchasers to support price in

aftermarketc. IPO Alternatives

i. Dutch Auctions, eg. Google 1. All bids above clearing price (price at which all offered shares can be

sold) accepted at clearing price (might be lower than bid), typically use pro-rata allocation (of all accepted bids) instead of the highest bidder receiving all requested shares.

2. Did not prevent money being left on the table (but this may be explainable by investor hesitation to enter into this type of IPO).

3. Did remove incentive/possibility of IPO allocations to favored customers, but did it increase underwriting fees? (Underwriters didn’t get any soft compensation b/c shares were automatically allocated, so they may have charged more…)

4. Example: Issuer offers to sell 100 sharesa. A bids for 50 shares at $10b. B bids for 40 shares at $8c. C bids for 20 shares at $6 Clearing Price = $6 (110 shares)

ii. “When Issued” Market - Illegal at the moment…

1. Stock can be traded before it’s issued (as in Treasury bill market securities), which would allow issuer to price offering at “market.”

2. “short-selling” = selling when you don’t have anything - what happens? There are many outstanding securities to fulfill K (even if not the issued ones).

3. SEC effectively prohibits through restrictions on (a) short sales (cannot cover shorts with IPO issued securities), Rule 105, and (b) trading unregistered securities

IV. The Registration Processa. Types of Issuers:

i. Well-Known Seasoned Issuer (Rule 405) = $700m in public equity float, eligible to use Form S-3 (if has issued $1b+ in registered debt, WKSI for purposes of issuing non-convertible debt, unless it also has $75+ million public equity float, in which case it is WKSI for equity also) = 30% of issuers, 95% of US market capitalization

ii. Seasoned Issuer, Large Reporting Companies - uses Form S-3 1. Reporting and Seasoned : 12 mo. timely Exchange Act reporting (must

report if over 500 shareholders, whether or not listed)2. Large : $75m+ in public common equity float (preferred stock not

included)iii. Unseasoned Issuer: IPO or does not qualify for S-3iv. Ineligible Issuers: shell or penny companies, or bad actors (violators of SEC,

etc.).b. Section 5 of the ’33 Act:

i. 5(a): No Sales before Registration Statement Effective1. (a) Unless a registration statement is in effect as to a security, it shall

be unlawful for any person, directly or indirectlya. (1) to . . . sell [a] security through the use or medium of any

prospectus or otherwise; orb. (2) to carry . . . in interstate commerce . . . any . . . security for

the purpose of sale or for delivery after sale.ii. 5(b): After filing, no written offers without prospectus conforming to S.10

1. (b) It shall be unlawful for any persona. (1) to . . . transmit any prospectus relating to any security with

respect to which a registration statement has been filed under this title, unless such prospectus meets the requirements of section 10; or

b. (2) to carry . . . any such security for the purpose of sale or for delivery after sale, unless accompanied or preceded by a prospectus that meets the requirements of subsection (a) of section 10.

iii. 5(c): No offers to buy or sell during pre-filing period1. (c) It shall be unlawful for any person . . . to offer to sell or offer to

buy through the use or medium of any prospectus or otherwise any security, unless a registration statement has been filed as to such

security, or while the registration statement is the subject of a refusal order or stop order or (prior to the effective date of the registration statement) any public proceeding or examination under section 8.

c. Important definitions useful to §5 i. ISSUER: §2(4) - “An issuer is any person who issues or proposes to issue

any security…”ii. UNDERWRITER: §2(a)(11) - “An underwriter is any person who has

purchased from an issuer with a view to, or offers or sells for an issuer [see below] in connection with, the distribution of any security. . . ; but such term shall not include a person whose interest is limited to a commission. . . . not in excess of the usual and customary distributors’ or sellers’ commission”. Note: As used in this paragraph the term issuer shall include any person directly or indirectly controlling or controlled by the issuer or under common control with the issuer Distribution: not defined in statutory, defined by case law, basically the same definition of “public offering”

iii. DEALER: §2(a)(12) - “A dealer is any person who engages either for all or part of his time, directly or indirectly, as agent, broker, or principal, in the business of offering, buying, selling, or otherwise dealing or trading in securities issued by another person…”

iv. PROSPECTUS: §2(10): [A prospectus means] “Any prospectus, notice, circular, advertisement, letter or communication, written or by radio or television, which offers a security for sale or confirms the sale of any security…”

d. Transactional Exemptions - §4(1) & (2)i. § 4. Provisions of §5 shall not apply to:

1. transactions by any person other than an issuer, underwriter, or dealer2. transactions by an issuer not involving any public offering

e. Liability For Violation of Section 5: i. 12(a)(1) : Any person who sells security in violation of §5 is liable to the

person purchasing such security.f. When is a registration statement “in effect”?

i. Automatic - §8 of 1933 - 20 days after filingii. Established

1. Rule 437 - delaying amendment filed w/RS postpones effectiveness until after SEC review (This is ALWAYS used.)

2. Rule 461 - request for acceleration of effectiveness filed with registration statement = immediate offering upon completion of SEC review (otherwise 20 days)

3. Rule 461(b) - SEC can deny request these grounds:a. No effort to make prospectus in plain English b. Preliminary prospectus is inaccurate or inadequatec. SEC is currently investigating issuerd. One of the underwriter does not meet financial responsibility

requirementse. An interested party has taken part in transactions artificially

affecting market price

f. Compensation hasn’t been cleared by NASDg. Pre-Filing Period (Gun-Jumping)

i. When does the period begin? When you reach informal agreement with underwriter…

ii. Basic Prohibitions:1. No sales: 5(a)2. No offers to buy or sell: 5(c)

a. Essentially any communication can be considered an offer to sell unless there is an exception

b. Release 3844: Any communication that conditions the market or arouses public interest is considered a solicitation of an offer to buy

iii. Exceptions to Prohibitions on Offers to Sell During Pre-Filing: 1. Person releasing information

a. § 4(1) - Anyone other than issuers, underwriters, dealers b. § 2(3) - Preliminary negotiations between issuer and

underwriters2. Research Reports by B/Ds:

a. Rule 137 (NON-PARTICIPATING = ANYTHING) i. Broker-dealer NOT participating in the distribution can

publish research reports on all issuers at all times if not receiving any compensation from anyone in the offering and publishes report in ordinary course.

b. Rule 138 – (PARTICIPATING = DIFF SECURITIES)i. broker-dealer can publish research reports on usual

business information on securities of a REPORTING issuer that are a different type than those being distributed.

c. Rule 139 – (Participating broker-dealer = ANYTHING)i. (a)(1) (Issuer Reports) can publish information he/she

would have done anyway on specific issuer if has done so in the past, not a re-initiation of reporting IF Issuer is a seasoned issuer (S-3) and not bad actor

ii. (a)(2) (Industry Report) can publish information he/she would have done anyway on industry if (i) includes similar info on substantial number of issuer’s industry/sub-industry, or contains comprehensive list of securities currently recommended by issuer, (ii) analysis of issuer given no particular prominence, and (iii) issuer is reporting/listed company and not bad actor

3. Rule 163 : WKSI FWPa. 163: WSKI Free Writing Prospectus Exempt from 5(c) at

all times as long as:

b. There is an appropriate legend directing potential buyers to look at prospectus, and one will be sent (or an email address/website listed to find this info)(163(b)(1)) AND

c. The free-writing prospectus is filed with SEC when RS is filed (163(b)(2)).

d. Oral and written offers ONLY by issuere. Note: basically, violations of the above are NOT violations of §

5(c) as long as issuer makes good-faith effort to conform to the rules.

4. Type of information released BY ISSUER a. Rule 135 : NOTICE (anybody!)

i. – Permits basic notice IN ANY MEDIUM of a public offering by the issuer

ii. Legend stating it is not an offeriii. Permissible info: issuer name, description of securities,

amount of offering, anticipate time, brief statement of manner and purpose (may NOT name u/w)

b. Rule 168 (reporting issuers) i. - factual business information + forward-looking

information (for big boys only) (in ordinary course) [UNDERWRITERS DO NOT QUALIFY]

c. Rule 169 (anybody) i. - actual business information (in ordinary course)

[UNDERWRITERS DO NOT QUALIFY]5. Timing of information release BY ISSUER

a. Rule 163A : 30 DAYSi. - communications 30 days or more before filing

exempt from 5(c) ii. so long as do not reference the offering (must take

reasonable steps to prevent further distribution within 30 days)

iii. Prospective UNDERWRITERS NOT PROTECTEDh. Waiting Period

i. Basic Prohibition: 1. do not want communications to be deemed improper prospectus under

5(b)2. prospectus defined broadly as any written communication including

TV or radioii. Prospectus Delivery Obligation (Rule 15(c)2-8 of ’34 Act):

1. requires participating b/ds to deliver preliminary prospectus to those who make written requests for one

iii. Permitted Selling Activities Under 5(b)(1) / Basic Exemptions1. Permits ORAL selling efforts (for bookbuilding)2. allows tombstone ads S.2(a)(10)(b)3. Preliminary Prospectus (Rule 430)

a. Prior to the effective date of an RS, §5(b)(1) is satisfied by the use of a prospectus that includes:

i. substantially the same info that will ultimately appear in the final prospectus under §10(a), except

ii. prelim. prospectus may exclude offering price & other info dependent on offering price

b. Bears a legend like the old red herring and the caption “Preliminary Prospectus.”

4. Free Writing Prospectuses may be §10(b) prospectus a. What is a FWP?

i. Any written communication that constitutes offer to sell securities subject to offering and that is NOT a statutory prospectus or other written communication permitted or exempted under other provisions of the securities laws

ii. Anything on issuer’s website or linked from website that could be deemed an offer

iii. Media: if give them information beyond registration statement, must be filed (for IPOs again this would require accompanied w/most recent P with price range which is practically impossible)

iv. Research Reports: can be deemed FWP if don’t fall undre Research Reports safe harbors (IPO Context mainly) BUT subjects you to liability under 12(a)(2) prospectus liabiliy, which is more stringent than 10b-5 disclosure liability that you would have gotten under the SH.

b. Eligibility:i. WKSIs: Can be used by WKSI at ANY TIME (Rule

163)ii. Seasonsed Issuers: Rule 433 allows FWP by

Seasoned issuers after filing RS (no prospectus delivery requirement, just need to notify via legend of filing of RS and URL for sec website where receipient can access prospectus)

iii. Non-reporting /unseasonsed issuers: allowed to use FWP if accompanied or preceded by most recent prospectus with price range (if material change since last) (if e-FWP, hyperlink to most recent prospectus qualifies)

c. Filing Requirement: i. A free writing prospectus generally must be filed with

the SEC if:1. prepared or used by the issuer, if it includes

material non-public information provided by the issuer; or

2. if it will be posted on a public web site or otherwise made available by offering participants in a broad, unrestricted distribution.

3. NO FILING REQUIREMENT if FWP from UW to customers through restricted access website or direct emails

d. Information in FWP:i. Cannot be inconsistent with Prospectus

ii. Prominent legend advising reader to read prospectus and how to get it or request it

5. Basic information permitted after registration (Rule 134)a. Information allowable:

i. Title of security and amounts being offeredii. Brief indication of type of business

iii. Price of securityiv. Brief descript of intended used of offerv. Name of underwriter

vi. Marketing plans (including place and times of road shows)

b. 134 info NEED NOT BE FILED WITH SECc. LEGEND REQUIRED (RS filed but not yet effective; where

prospectus may be obtained)6. Rule 134(d) Permits WRITTEN Solicitation of Interest

a. When 134 information accompanied or preceded by prospectusb. And accompanied by legend saying that sale cant be completed

until after effective date7. Road Shows

a. Presentations attended by underwriters, officers of issuer, analysts, sec professionals, institutional investors

i. NOT attended by RETAIL investors b. OK if only ORAL and only prelim prospectus delivered c. SEC has approved use of electronic media

i. OK:1. Audio video tapes distributed to specified

individuals 2. Video Conferencing 3. Password protected access to website to view 4. Subject to caveat that cannot be downloaded

and distributed to unqualified persons d. Charles Schwab No Action – allowing access to individuals

with “significant” trading experience (24 trades annually or equity position > $500K) – high water mark

e. Live, real-time road shows to a live audience that are simultaneously transmitted graphically will not be a graphic communication, and therefore not a written communication, or a FWP. So okay. (ACR 126-128)

f. Road shows that do not originate live, in real-time to a live audience and are graphically transmitted are electronic road shows that will be considered written communications and, therefore, FWPs. So may be okay under FWP Rules 164 and 433. (ACR 126-128)

8. Factual Business Information (Rules 168, 169) by issuers9. Research Reports (Rules 137, 138, 139) by broker dealers

i. Post-Effective Periodi. Basic Prohibitions:

1. 5(b)(2) : no sale before delivery (ACCESS) of a FINAL prospectus that meets the 10(a) requirements

a. [this does NOT apply to unsolicited broker’s market transactions]

b. Confirmations of sale can be sent electronically, but require consent.

ii. Free Writing: once prospectus delivery, no restrictions on communications!!iii. Issuer’s Obligation to Deliver Prospectus: Access Equals Delivery (Rule

172)1. I. Access = Delivery:

a. A final prospectus will be deemed to precede or accompany a security for sale for purposes of §5(b)(2) as long as:

i. the final prospectus meeting the reqm’ts of §10(a) is filed, or

ii. the issuer will make a GF & reasonable effort to file it w/SEC as part of the RS w/in the req’d Rule 424 prospectus filing timeframe

b. Seems that there’s no consent reqm’t2. II. §5(b)(1) says: if RS is filed, can’t use a prospectus that d/n meet §10.

But under the wide §2(a)(10) language, confirmations are prob prospectuses… hence under Rule 172…

a. After Effective Date, the following are exempt from 5(b)(1):i. Written confirmations of sales, and ii. Notices of allocation of securities sold or to be sold

iv. Underwriter’s Prospectus Delivery Obligation:1. IPO: uws must deliver prelim prospectus at least 48 hrs to before

sending confirmation of sale2. but no final prospectus delivery requirement (acces = delivery) as a

condition of mailing confirmation of sale3. notice of sale must occur within 2 business days of sale

v. Offering Participant’s obligation to deliver 10(a) prospectus pursuant to 4(3): Rule 173: Notice of Registration: (no §5 liability for violating)

1. In a transaction involving a sale by an issuer or UW to a purchaser; or a sale in which the final prospectus delivery requirements apply:

a. not later that 2 days after sale, b. each UW or D will give a final prospectus to each purchaser,

or

c. will give notice that such is not req’d due to Rule 1722. Investor can request a final prospectus.

vi. For How Long After the ED, Must Prospectuses be Delivered?1. Issuer : Indefinitely, §4(1) 2. UW or B/D Holding Original Allotment : Indefinitely, for sales from

original allotment, §4(3)(C)3. Resales by Dealers (ie. Securities Firms §2(a)(12)): Depends on info

avail on issuer, §4(3)(B)a. 90 days after ED or 1st date of bona fide offering to the public,

if it’s the issuer’s first registered offering, §4(3) final sentenceb. 40 days after ED or 1st date of bona fide offering to the public,

if the issuer has made other registered offerings, §4(3)(B)c. 25 days , if the securities are listed on a stock exchange or

NASDAQ, Rule 174(d)d. 0 days , if the issuer was a reporting company when it filed its

RS, Rule 174(b)e. 0 days , if the RS relates to offerings from a shelf and the

relevant §4(3) period has already expired for the first timef. 0 days , if dealer does not solicit client’s interest, §4(4)

vii. Rule 174 : Delivery of Prospectus by Dealers1. Provides # of days for which dealers must continue to deliver

prospectuses after ED2. See immediately above for key provisions3. Any of the provisions of Rule 174, can be satisfied by Rule 1724. 174(b): no prospectus delivery requirement if issuer is a reporting

companyj. Updating/Correcting the Registration Statement

i. POST-EFFECTIVE AMENDMENTS TO REGISTATION STATEMENT1. Post effective amendments halt distribution efforts while SEC is

approving2. Logical Progression to determine whether chg to Prospectus reqs

Amendment to RS:a. Liability stems from §12(a)(2), which prohibits sales via

materially deficient prospectuses, which are deficient anytime (ie. can become deficient over time)

b. If changes arise that make the prospectus misleading, or that add info that now should be req’d in the prospectus, the prospectus can be amended.

c. But, does the RS then need to be amended via post-effective amendment? Specifically, §11 liability only judges the RS at the time it becomes effective…

i. §10(a) says the prospectus should contain the info contained in the RS.”

ii. So, if language in the prospectus is being changed, a post effective amendment to the RS is req’d so that the prospectus will still contain the same info as the RS

iii. But, if new info is added to the prospectus, it still contains the same info as the RS, so no post effective Amendment to the RS is req’d

3. Materiality – a. Even given this logical progression, the SEC says a material

change merits a post-effective amendment (Release No. 6276). b. Rule 424(a): substantive changes from or additions to a

prospectus previously filed w/the SEC as part of a registration need be filed as an amendment to the RS.

c. So Materiality and Substantive are treated as same here 4. Stickering:

a. a non-material change allows for a sticker containing the new information to be placed on the prospectus according to the procedure in Rule 424(b)(3)-(5)

b. STALE PROSPECTUS REQUIREMENT: NOT AN AMENDMENT (NOT NEW LIABILITY) whenever a prospectus is used >9 mo after the registration statement became effective, the info must not date from more than 16 mo prior to use. §10(a)(3) demands that more recent info be substituted in such cases. This more recent info doesn’t need to be filed as a post-effective amendment though, can use stickers; however ten copies of the new prospectus need to filed w/ the SEC under Rule 427.

c. WHY PREFER STICKERING?i. Must await SEC Approval of Post-Effective

Amendments, so distribution must stop until commission makes effective with its power under Section 8(c)

ii. §11 Liability clock is reset as of the date of amendment, §8(c) – new ED. Problem: Once post-effective amendment is approved, it reaffirms all that then appears in the RS. So, anything in the original RS that’s no longer true can come back to bite you. Whole RS has to be rechecked – timely, costly, and may miss something.

5. REASONS TO AMEND a. Registration Statement Inaccurate When Filed : if it is later

discovered that the RS was materially misleading at the time that it was filed, it must be amended immediately to avoid § 11 liability.

b. Registration Statement Becomes Misleading : if a post-effective event makes the RS materially misleading, the prospectus , which is part of the RS [§10(a)], must be updated to avoid §12(a)(2) liability; whether this requires a post-effective amendment to the RS depends on whether one can

say that the amended prospectus still “contain[s] the info contained in the RS” as per §10(a).

ii. Sec. 8: SEC POWERS TO COMPEL AMENDMENT1. §8(a): Automatic Effectiveness

a. RS is effective win 20 days of filingb. but Rule 472 allows for permanent delaying amendment

2. §8(b): REFUSAL ORDER: a. “if it appears to SEC that registration is incomplete or

inaccurate in any material respect SEC may issue an order prior to ED of registration refusing to permit such a statement to become effective”

b. Not so powerful b/c Error has to be pretty glaring - does not apply where misleading feature of RS is not apparent on its face (ie. where misleading character can only be discerned from conditions or facts not appearing in the RS)

c. SEC has to be on the ball since refusal order must be ordered before RS becomes effective (which can come on fast via 20 day automatic period)

d. Under 5(c), no offers to buy or sell can be made when refusal order has been issued

3. §8(d) STOP ORDER (more popular): a. If appears RS includes an untrue statement of a material fact or

omits to state a material fact, SEC may issue an stop order suspending the effectiveness of the RS.

b. Indicates that SEC has found RS disclosures materially misleading.

c. Only applies to errors present when RS became effectived. D/n apply where post-effective development renders a

previously accurate RS misleading (similar to §11)e. When proper amendment is made, §8(d) stop order is liftedf. Under 5(c), no offers to buy or sell can be made when stop

order has been issued4. §8(c) SEC APPROVAL OF AMENDMENT:

a. an amendment filed after the ED of the RS shall become effective on such date as the SEC may determine, having due regard to the public interest and protection of investors

5. §8(e) – INVESTIGATIONa. Not publicb. But, triggers 5(c) bar if RS is not yet effective

6. Sec. 8A: SEC can obtain a cease and desist order7. Refusal or stop order triggers ‘bad boy’ disqualifier

iii. WITHDRAWAL of the Registration Statement1. SEC Acquiescence Required : If issuer wants to abandon the effort,

may w/draw RS or amendments thereto if SEC does not object within 15 days of the withdrawal notice; if SEC finds the w/drawal consistent w/the public interest and protection of investors they’ll not object

(Rule 477); however even if W/D, Commission often publishes opinion setting forth deficiencies to inform investors

iv. PRIVATE ACTIONS: RIGHT OF RESCISION1. Sec. 12(a)(1): if sell or offer in violation of Sec. 5(b) (“unlawful….to

sell security unless accompanied by prospectus that meets Sec. 10(a)”)…liable for consideration paid w/ interest less income received OR damages

2. Sec. 12(a)(2): any offer by means of prospectus or oral communication which contains an untrue statement or material fact (don’t need to have violation of Sec. 5) and cant sustain BOP that didn’t know of untruth shall be liable to purchaser

V. Independent Research Analystsa. 2003/2004 Settlement on Investment Banking/Research :

i. April 2003 Settlement (10 firms) plus August 2004 (2 firms)ii. Total cost = $1.5B

iii. SEC and State Fines: $525Miv. SEC Victims Fund: $417Mv. Investor Ed: $105M

vi. Funding “independent” securities research: $460Mvii. Structural Changes

1. Separate Research and IB2. Analyst comp cannot be based on IB revenues and cannot be

determined by I-Bankers3. Analysts cannot market securities being underwritten (eg. no road

shows)4. Research reports must disclose that company may seek to do biz

w/covered firmsviii. Comments:

1. So this settlement creates a regulatory regime through the process of settlement b/c the firms in the settlement reflect some huge % of the total market

2. No hearing, no legislative action, etc. Is this the right approach?b. Regulation AC – analyst certification mandated by section 501 of Sarbanes-Oxley

i. Certifications in research reports:1. Views are those of the analyst2. Relation between research and compensation

ii. Certifications in connection with public appearance1. Views are those of the analyst2. No part of compensation depends on views3. Keep records of public appearances

VI. Efficient Capital Markets Hypothesisa. ECMH:

i. Weak: The market incorporates all information based on past prices1. Studies show prior prices are independent of each other, ie. can’t

extrapolate future price from past price changes onlyii. Semi-strong: the market incorporates all publicly available information

1. Consider: Since the theory assumes info is incorporated quickly, it may be that the actual presence of this version fluctuates with factors like amount of analyst coverage, number of sophisticated institutional investors holding securities.

2. Open Q: This version suggests investors can’t generally beat the market. If that’s true, why even try, ie. why study the info that’s released? And if so, doesn’t that undermine the idea underlying this version, ie. that people study the info released and act on it?

iii. Strong: Market incorporates ALL information1. No empirical info to support existence of this form

b. Noise - Pricing influences not assoc’d w/rational expectations about asset valuesi. Fads, fashions, seasonal effects, behavioral finance critique, see below

ii. Empirical evidence, and trading strategies of major market participants suggests markets are quite noisy

iii. Behavioral Finance critique of the Rational Investor Hypothesis1. Various psychological elements cut against ECMH: Loss Aversion;

Cognitive Conservatism; Over-reaction to new info; Herd influence; Overconfidence

c. Consequences of Disproof, i.e., irrational investor base?i. No regulation of securities, b/c disclosure wouldn’t make a difference anyway

ii. But not all people are irrational all the time, so it can be useful.VII. Shelf Registration

a. Integrated Disclosurei. Move to eliminate duplication due to disparate ’33 and ’34 Act reqm’ts

ii. Two main features:1. Standard disclosure reqm’ts for docs filed under both the ’33 and ’34

Actsa. Reg S-X for financial items b. Reg S-K for non financial items

2. Allow large companies to satisfy ’33 Act registration stmt reqm’ts for company (but not transaction) specific info, by incorporating info from ’34 Act filings (eg. 10K, 10Q, 8K)

iii. Forms:1. S-1

a. Certain reporting issuers may incorporate by reference into their S-1 info from their previously filed ’34 Act reports/docs

b. Eligible issuers have filed at least one annual report and that are current in their reporting obligation under the ‘34 Act

c. Conditionsi. Must update for material changes not yet reported in a

’34 Act report of some kind (10K, 10Q, 8K, etc.)ii. Must make the incorporated reports eligible, either via

an issuer web-site containing them, or hyperlinks to Edgar

iii. No “forward incorporation by reference” of docs filed post Effective Date

iv. Must include a list of the incorporated reports and materials

d. If the issuer is not eligible for these new S-1 options, presumably, they’re relegated to the old S-1 conditions, as below

i. Requires complete disclosure in prospectusii. No incorporation by reference

iii. Probably typically used in IPO situations2. S-3

a. Used by: Registrant who has been in the ’34 Act reporting system for 1+ yrs; and, if offering new equity securities has a min public float of $75M, or if offering investment grade debt no float reqm’t

b. Info on registrant is fully incorporated by reference to ’34 Act reports

c. Not req’d to include info on registrant in prospectus unless there’s a material change

d. Note: Relies on ECMHb. Shelf Registration (Rule 415)

i. Summary:1. Must qualify for Shelf Registration, Rule 415(a)(1)2. Allows continuous or delayed sale of securities covered by Shelf

Registration statement3. Must file Shelf Registration statement with SEC4. Limitations, Rule 415(a)(2)-(5)5. Post-Effective Amendments to Registration Statement:

a. All issuers must amend RS for material changes in planb. of distributionc. Non S-3 issuers must amend for “fundamental” changes in

material facts, S-3’s for non-incorporated (by prior reports) material changes

ii. Rule 415:1. (a)(3) Requirement to Update the RS, under 512(a)(1) of Reg S-K:

a. S-3 filers don’t need to constantly update the Shelf RS for developments, unless those developments are MATERIAL (no need for post-eff. Amendment if changes already in periodic reports)

b. Non-S-3 filers must update for changes that constitute FUNDAMENTAL changes from what was filed in POST-EFFECTIVE AMENDMENT. This std is higher than the standard for S-3 filers

2. (a)(4) [ACR: If an issuer is registering a primary equity shelf offering under 415(a)(1)(x), the offering may be “at the market”. There are no limitations on the size of such an offering.]

3. Duration: (a)(5) Shelf registrations for S-3 filers are valid for 3 years. If a new RS is filed before 3 yrs elapse:

i. In case of an Automatic Shelf RS, it will be effective immediately

ii. In cases other than an Auto Shelf RS, the issuer can keep issuing under the old RS for up to 180 days or until the new RS goes effective, whichever is sooner

iii. under (a)(6): there are opportunities to continue issuing off an old, expired shelf if a new shelf registration statement has been filed

4. Amount of securities: shelf registrations for non-S-3 filers limited to securities reasonably expected to be sold within two years from the initial effective date of the registration.

iii. Automatic Shelf Registration:1. Defined (Rule 405) : Registration Statement filed on S-3 / F-3 by a

WKSI (as of date of filing most recent shelf registration statement/amendment (later of))

2. Immediate Effectiveness : Auto Shelf RS and post-effective amendments become effective immediately on filing, pursuant to Rule 462(e) and (f)

3. Flexibility : Also, allows eligible issuers to add add’l classes of securities & to add eligible majority-owned subs as add’l registrants after an automatic shelf RS is effective

4. Info Reqm’ts : New Rule 430B allows omission of more info from the base prospectus in an automatic shelf RS than in a regular shelf offering RS

5. Duration : Issuers must file new automatic shelf RSs every 3 years that will, in effect, restate their then-current RS and amend it, as they deem appropriate. Issuers will be prohibited from issuing securities off an automatic shelf RS that is more than 3 years old. But can just file a new one and so be seamless.

6. Rationales :a. facilitate immediate mkt access & promote efficient capital

formation, w/o at same time diminishing investor protectionb. flexibility to take advantage of mkt windows, to structure

securities on a real-time basis to accommodate issuer needs or investor demand, and to determine or change the plan of distro of securities as issuers elect in response to changing mkt conditions

iv. Rule 430B – Info Omittable from Shelf RS Prospectus, Updating the Prospectus

1. Rule 430B is a shelf offering corollary to existing Rule 430A, in that it describes the type of information that primary shelf eligible and automatic shelf issuers may omit from a base prospectus in a Rule 415 offering and include instead elsewhere

2. Paraphraseda. a) A base prospectus filed as part of an RS for shelf

registrations under 415(a)(1)(x), auto shelf registrations under

§415(a), (and others) may omit info not known or knowable, per Rule 409.

b. If the Prospectus is part of an Auto Shelf RS, it can additionally omit:

i. whether the offering is a primary offering or an offering on behalf of persons other than the issuer, or a combination thereof,

ii. the plan of distribution for the securities, iii. a description of the securities registered other than an

identification of the name or class of such securities, and

iv. the identification of other issuers.c. d) Info omitted from a prospectus that’s part of an effective

RS, in reliance on the above, can be added to the prospectus by:

i. (1) A post-effective amendment to the RS;ii. (2) A prospectus filed pursuant to Rule 424(b); or

iii. (3) If the applicable form permits, including the info in the issuer’s periodic or current reports filed under §§ 13 or 15(d) of 34 Act that are incorporated or incorporated by reference into the prospectus that is part of the RS.

1. But this action must meet the reqm’ts of 430B(h), which essentially req’s the issuer to file a Rule 424 notice w/the SEC and a supplement to the prospectus identifying the reports that incorporate the omitted info

d. (f)(2): for purposes of Section 11 liability, effective date is now the date of the new amendment.

v. Rule 424(b)1. A prospectus used in connection with a Rule 415(a)(1)(x) shelf

offering (amongst other shelf offerings), that includes info previously omitted from the prospectus filed as part of an effective RS (omitted in reliance on 430B), shall be filed with the SEC w/in 2 biz days

vi. Benefits1. File RS once, then just update2. Timing flexibility to get ideal pricing

vii. Risk1. May damp current trading, b/c people expect some new dilutive issue

to come on market at any time2. UWs complain this denies them the time req’d for due diligence under

§11 of the ’33 Act 3. UWs also complain that shelf offerings sharply reduce their role, since

issuers can go to market more easily4. Short time between amendments and issuance may not give the market

enough time to digest the new information.VIII. Section 11 Liability

a. § 11(a) Civil Liability under §11(a)i. §11(a):

1. If any part of an RS,2. when such part became effective,3. contained an untrue statement of a material fact or4. omitted to state a material fact required to be stated therein (MMO) or

necessary to make the statement therein not misleading5. any person acquiring such security can sue6. unless he knew of the MMO at the time of acquisition

b. Plaintiffsi. Private parties

ii. §11(a) does not require privity between the issuer and the purchaser in a transaction

1. liable to anybody who acquires the securities pursuant to false RS, not just those who purchase in the initial offering

2. Hertzberg v. Dignity Partners , 9th Cir. 1999, CB 473a. §12: seller is liable “to the person purchasing such security

from him” Implies privity reqm’tb. §11 only says “any person purchasing such security.”

i. Implies P can sue issuer, even if purchased in aftermarket

c. BUT P must still be able to show that the securities were associated w/the particular defective RS

iii. Tracing Problem1. If shares can’t be traced to that specific RS, then no §11 standing. 2. Big companies have many RSs, so any purchase made in the

aftermarket cannot be traced to the specific RSiv. No Reliance

1. Need not show reliance unless bought 1+ yrs after RS ED and 12 months financials were issued

c. Defendantsi. Issuer: no diligence defenses

1. Draconian SL on issuers - §11(a)a. Knowledge, reliance, causation not req’d

i. Cf. Tort of Deceit, requiring reliance and scienterb. Misstatement is all that matters, regardless of what the issuer

knewc. Deterrence, not compensation

2. §11(b) defenses – Issuer explicitly excludedii. Liable parties who have diligence defenses

1. Every RS signer; 2. Directors of issuer at time of RS filing3. every person named in the RS as about to become a director4. every accountant, engineer, or any person (generally, experts) named

as preparing or certifying any part of the RS5. every UW

iii. Form of Liability1. Generally Joint and Several (JSL)2. Exceptions

a. Non-managing UWs’ liability limited to amt of their participation in the offering (§11(e))

b. Outside director’s liability ltd to damage he caused, unless he knowingly violated securities laws

3. JSL on Controlling persons of Section 11 Defs – SA §15a. if you control a liable party, you can be liable unless no

knowledge of or no reasonable ground to believe the party was liable

b. e.g., holding company that owns the UWsd. SOL - §13

i. suit must be brought w/in 1 yr after MMO was or s/h/b discovered; absolute bar 3 yrs after public offering

e. §11(b) Defensesi. §11(b)(1) – Whistle-blowing

1. insider can avoid liability if he resigns and notifies SEC (to alert them that something is amiss) before RS becomes effective

ii. Due Diligence Defenses – for NON-issuers1. §11(b)(3)(A) – due diligence defense for non-expertised portions of

the RSa. After reasonable investigation, has reasonable ground to

believe (and did believe) at time of RS effectiveness all statements were true and no req’d material fact was omitted or necessary to make statements not misleading

2. §11(b)(3)(B) – allows experts to rely on their own due diligence defense

a. After reasonable investigation, has reasonable ground to believe (and did believe) at time of RS effectiveness all statements were true and no req’d material fact was omitted or necessary to make statements not misleading

3. §11(b)(3)(C) – reliance defense for expertised portions of the RSa. Non expert reviewing expertised portion.b. Had NO reasonable ground to believe and DID NOT

BELIEVE” that there was any inaccuracy or omission.4. Define reasonable?

a. Reasonable belief or investigation is that “required of a reasonable person in the mgt of his own property.” §11(b)(3)(A)

b. Circularc. Rule 176 elaborates this into a sliding scale, considering

relevant circs, incl: i. Reasonable reliance on officers, employees and others

ii. Type of underwriting arrangement and availability of info

iii. whether for docs incorporated by reference D had responsibility for the fact or doc at the time of filing from which it was incorp’d by reference

iv. Suggests that Shelf Registrations merit special consideration that takes into acct factors such as actor’s identity, role, the type of security, etc.

f. Escott v. BarChrisi. 2 misstatement groups

1. #1) Misstated financials. Expertise section2. #2) Misstated plans for use of proceeds. Non-expertise section.

ii. Defendants1. Russo (CEO, D, RS signer)

a. Liable for non-expertised portion MMO about use of proceedsb. Liable for expertised financials because he knew they were

false2. Birnbaum – (Outside D, RS signer)

a. Liable for not investigating non-expertised portions; reliance defense OK

3. Auslander – (New D (who is also an attorney though not for the issuer)a. Liable for non-expertised: must prevent RS effectiveness if you

don’t have enough time to conduct a reasonable investigation (his questions were not probing enough!)

4. Coleman – (UW/D) –expertise defense; but failed due diligence duty5. Drexel – (UW) – failed both expertised and non-expertised duties6. Drinker, Biddle – (outside lawyers)

a. Lawyers are not liable under §11i. Considered agents of the UW

ii. Still subject to state law (malpractice) and §10(b)(5)b. Can be liable for expertised legal opinions in RS

7. Peat, Marwick (auditors) – liable for the expertised portionsg. Evaluating the Due Diligence Regime

i. Cost ineffective: incredibly expensive undertaking1. investors may bear substantial cost of diligence2. UWs may under-price offerings to compensate for liability risk3. Competitive bidding by UWs for offerings gives them disincentives to

engage in costly diligence, especially in the shelf. ii. Does strict liability for issuers make sense?

1. penalty levied on shareholders (sh’s) for investigation and settlement costs, robbing Peter to pay Paul

2. Increases cost of capitaliii. Alternatives: Expanding or limiting liable parties

1. leave investigation to market forces / reputation2. limit liability to reckless and intentional violations3. limit to issuers and experts who have best access to info/data

a. Issuer might be bankrupt by time of suit

i. Holding other deep pocket parties liable serves compensation and deterrence

4. Attorney liability could create a more accurate and reliable regimea. Lawyers are already doing general due diligenceb. §11 inconsistent w/SOx notion of lawyers as gatekeepers

h. Due Diligence in a Shelf Offeringi. More difficult than regular public offerings because less time to investigate

ii. Worldcom (civil liability, but there is always the specter of criminal liability for willful security violations)

1. Facts: 2 bond offerings on shelf; misstatements in 2000 and 2001 RS’s

a. blatant fraud to maintain line expenses over revenues (E/R) by capitalizing expenditures that should be deducted from income

2. Audited Financials a. Holding: UW’s should have recognized E/R anomaliesb. Counterarguments

i. this info was public and nobody else noticed or reactedii. liability obviates efficiency advantages of the shelf

3. Unaudited Financials a. Holding

i. Unaudited: covered by higher due diligence defense, not reliance

1. UW reliance on comfort letter insufficientii. Unreasonable due diligence beyond the comfort letter

1. Cursory investigation; limited contact w/issuer2. Had knowledge of financial difficulties

b. Counterargumentsi. Huge ↑ in UW expenses – they must audit interim

financials to avoid liability4. Rule 176 did not protect UWs because judge held that the level of due

diligence in shelf offering is the same as any other offering5. Scott: this is debatable. Judge might be wrong.

i. Rule 176 – Limits on Due Diligencei. Attempt to create some safe harbor for due diligence obligations

1. Look at relevant circumstances, including a. Reasonable reliance on officers, employees and othersb. Type of underwriting arrangement and availability of infoc. whether documents incorporated by reference the defendant

had responsibility for the fact or document at the time of filing from which it was incorporated by reference

2. Suggests that Shelf Registrations do merit special considerationii. Codifies a sliding scale approach to liability

1. E.g., in BarChris: insiders had greater duty than outsiders and insiders with special expertise had even higher duty

j. §18 of the 1934 Act – Liability for Misstatements in ’34 Act Filings

i. Any person who makes false or misleading statement in 34A filing (at time of filing) is liable to any person who, in reliance on such statement, purchased the security, if he did not know the statement was false or misleading

ii. focuses on those who actually prepare the financials1. might be better approach than 33 Act §11

k. Damages Under Section 11(e)i. Negative Causation

1. §11(e) – If D proves that part or all of the claimed damages represents something other than depreciation in value due to errors in the RS for which he’s liable, that fraction of the damages is not recoverable

2. Tempers harshness of §11 liability substantially3. Damages from factors unrelated to the misstatement/s create the

qualification to usual rescissory recovery4. Turns into something closer to “out of pocket” damages, similar to

fraud5. D’s victory in Akerman is unusual. Negative causation is a difficult

defense to prove6. Akerman v. Oryx Communications (2d Cir 1987)

a. Disclose misstatement in June 30 registration to SEC on Oct 15th; tell public Nov 10th. Sued on Nov 25th. Stock rises .25 b/w the disclosure and suit.

b. D does a study which claims that the stock movement before disclosure (decline) was consistent with its cohort of fellow IPOs.

c. Plaintiff shows an opposing studyd. Ct finds that D met §11(e) burden by est. that the

misstatements were barely material and that public failed to react adversely to disclosure

ii. Measure of Damages 1. As indicated in Akerman, §11 creates presumption of recissionary

damages based on:a. Difference between amt paid ( so long as < offering price) and

i. Its value at time of suit,ii. Consideration received on resale if sold before suit, or

iii. Consideration received if sold after suit, but before judgment, IF less than a) would produce

b. Use of “value” lets P argue market price at time of suit was improperly inflated, to gain larger recovery

c. But an individual’s recovery is therefore capped at offering price

d. Aggregate Cap, §11(g) – amt recoverable under §11 will never exceed price at which security was offered to the public

2. Dura Pharmeceuticals v. Broudo (SCOTUS 2005, cbs 34)a. Addresses pleading requirement for loss causationb. 9th Circuit

i. SH complaint, alleging only that SH’s paid “artificially high” price in “reliance on integrity of the market”

ii. B/c of false claims that Dura expected to profit from its new product, ct held that Ps adequately pleaded that price was overstated and sufficiently ID’d cause

c. SCOTUS reverses 9th Cir view of loss causation, goes with the other circuits

i. In FOTM cases, inflated purchase price is not itself a loss and cannot be the only proximate cause of one

1. Logic: you can sell at whatever the price is, so whether you win or lose depends on what you do and what happens next. And the longer the stock is held, the more factors can influence the price

ii. Must show an economic loss, once truth becomes known and price shakes out

iii. Also argues policy: protections are to maintain public confidence by deterring fraud, not to act as general market insurance against price declines

iv. And rather, PSLRA requires securities that fraud complaints:

1. Specify each misleading statement2. Set forth facts on which belief that statement is

misleading was formed3. State w/ particularity facts giving rise to strong

inference that D acted w/ required state of mind4. And finally, Plaintiffs must prove

misrepresentations caused lossiii. Compare § 11 to Rule 10b-5:

1. Difference between measure of damages in 10b-5 and 11: a. Section 11: diff between purchase price and the price at which

the person sellsb. No damage cap in 10b-5

2. Burden of proof:a. On defendant in Section 11 and on plaintiff in 10b-5

3. Why these differences between 11 and 10b-5?a. Section 11 covers the registration statementb. 11 is more strict liability b/c congress cares more about

integrity of reg statementc. Confers more confidence in public offeringsd. It’s a balancing test: to get more damages, have to prove more

(10b-5)l. Apportionment of Liability under Section 11

i. Joint and Several Liability (JSL) for most § 11 Defendants1. Modified rules for UWs and outside directors

a. UWs: Excluding managing UW, no UW is liable in excess of total price of his underwriting offered to public

b. Outside Directors:i. If the outside director was a knowing violator, JSL

ii. PSLRA added §11(f)(2)(A) to switch to proportionate liability, in absence of knowing misconduct

iii. Additional “uncollectible share” liability based on wealth of P

1. If NW < 200k and damages >10% of NW, outside directors JSL

2. else, proportionately liable for uncollectible share but this liability cannnot exceed 50% of directors’ total proportionate liability

ii. Indemnfication1. SEC views issuer indemnification for liability of directors and officers

found in violation of Section 11 to be against public policy and hence unenforceable

2. Reg S-K, Item 512(h)(3) requires issuer facing such indemnification claim to present matter to court to judge enforceability

3. BUT: directors then just force companies to get D&O insurance, which the SEC does NOT proscribe! (irrational policy stance)

iii. Contribution1. 11(f): Contribution clauses valid and enforceable because shares the

burden among equal wrongdoers.2. Outside directors can seek contribution from others, while others can

only seek proportionate contribution from outside directors3. Outside directors who settle private actions prior to final verdicts

discharged from all claims for contribution brought by other partiesiv. PSLRA: Settlement Discharge,’34 Act 21D(f)(7)

1. A) In General:a. A covered person [includes outside director, (f)(10)(c)] who

settles any private action at any time…shall be discharged from all claims for contribution brought by other persons. [The court shall enter a bar order precluding]…all future claims for contribution arising out of the action—

i. (i) by any person against the settling covered person; and

ii. (ii) by the settling covered person against any person, other than a person whose liability has been extinguished by the settlement of the settling covered person.

2. B) Reduction.—a. If a covered person enters into a settlement w/P prior to final

verdict or judgment, the verdict or judgment shall be reduced by the greater of—

i. (i) an amt that corresponds to the percentage of responsibility of that covered person; or

ii. (ii) the amount paid to the plaintiff by that covered person.

b. WorldCom Settlement: i. bar order thrown out b/c [?] (non-settling parties

objected b/c they felt the judgment amt should have been reduced by the proportionate liability of the settlers ($3B) rather than by their proportionate ability to pay ($100M))

ii. Brought in all parties to settle so nobody could object v. Personal Liability for Directors:

1. Politically motivated prosecutor could force personal exposure through Hammer Clause: allows insurance company to require settlement if in their judgment its acceptable, allowing them to pay less and forcing director to pay more out of pocket

2. but today, AIG at least has eliminated hammer clause.IX. Liability under Section 12(a)(1), 12(a)(2), and 17(a)

a. Summary of Liability Rules under ’33 Act: (see Class Slides 12, p.1 for chart)i. Wide range of remedies (10b-5 applies to everything)

ii. Strictest rules are under Sections 11 and 12(a)(1) with respect to the registration and offering process

iii. Exempt securities covered by 12(a)((2)iv. Secondary private offerings are only covered by 10b-5, Gustafsonv. Does it make sense to have different liability standards for different types of

securities violations? Probably, since cost-benefit trade-offs are different in different situations

b. 17(a): General Anti-Fraud provision of ’33 Acti. Only covers fraud in offer or sale supplanted by 10b-5, created by SEC to

cover ALL securities fraudii. No private right of action

c. 12(a)(1): Liability for offer or sale in violation of Section 5i. §12(a)(1): Any person who offers or sells a security in violation of Section 5

shall be liable to the person purchasing the security from him…ii. Purpose: To enforce the registration and gun-jumping reqm’ts of §5

(generally applies to improperly unregistered securities)iii. Available Remedies:

1. Rescind transaction and get money back + interest, or2. Recover recissionary damages if stock has been sold

iv. Requirements1. D/n require proof of any misrepresentation2. Requires privity: issuer usually would not be liable then in a major

securities offering, it would be the underwriterv. SL Standard

1. SL against sellers of unregistered securities when no exemption applies

2. Once there’s a violation of §5, later compliance does not curea. Eg. Defective “offer” during waiting period, is not cured by

subsequent compliant salevi. SOL (SA §13) –

1. Suit must be brought w/in 1 yr after the violation. 2. In no event, more than 3 years after security was bona fide offered to

the publicvii. Possible Defendants

1. A person is not a seller under §12(a)(1) unless he is motivated to serve his own financial interests, or those of the ‘real’ seller (i.e. Pinter).

2. Unclear: “Any person who offers or sells” to “the person purchasing such security from him”

3. Pinter v. Dahl (CB 502) a. Facts: Dahl, a CA real estate broker and occasional oil

investor, invests $310,000 in oil properties with Pinter, a TX O&G producer. Dahl later told friends and family about the venture, and without receiving commissions, helped them complete subscription forms, prepared by Pinter, for unregistered securities in the oil properties. The venture failed, leading Dahl and his friends to sue Pinter under §12(a)(1) (recession from sellers for failing to comply w/ §5). Pinter sued Dahl for contribution.

b. Issue: Was Dahl a “seller” of securities for purposes of §12(a)(1)?

c. Holding/Rationale: i. A person is not a seller under §12(a)(1) unless he is

motivated to serve his own financial interests, or those of the ‘real’ seller (i.e. Pinter).

ii. Court observes that while §12(a)(1) was intended to cover those who solicit sales (that is the stage of the transaction where investors need protection), §2(3) defines “sale/sell/offer” to include ~“every contract of sale or offer for disposition of a security…for value.” Accordingly, such a solicitor is not a seller under §12(a)(1) if his efforts are “gratuitous”. Rather, must be motivated to serve his own financial interests, or those of the ‘real’ seller.

iii. Note: This definition of “seller” applies to §12(a)(2) too. (CB 516).

d. Proximate Cause / Collateral Participants: Ct rejected the idea that collateral participants who helped but did not solicit sales are reached by §12(a)(1)’s SL

viii. INNACURATE PROSPECTUSES SUBJECT ISSUERS TO STRICT LIABILITY UNDER SECTION 12(a)(1):

1. misinformation has the effect of voiding the prospectus; the court implied that info must be true and correct and if it is not, the requirements of 10(a) – that a prospectus contain material info and all info in registration statement - and 5(b)(2) are not met; this leads to private actions under Sec 12(a)(1) allowing for rescission; creates S/L w/o defenses for mistakes in prospectuses; (SEC v. Manor Nursing Centers)

2. [the key difference is that §11 liability stems from the registration statement at effectivity date, rather than prospectus anytime as under §12(a)(2)]

3. SEC v. Manor Nursing , 458 F.2d 1082 (2d Cir. 1972) Inaccurate Prospectuses Flunk § 5(b) on Strict Liability. Manor Nursing decides to violate all sorts of conditions and commitments it sets forth in its prospectus (after registration statement became effective), and clearly falls afoul of the antifraud provisions of the ’33 Act. The question is whether it also violates the prospectus delivery requirements of § 5(b). HELD: implicit in the statutory 10(a) provision that the prospectus contain certain info is the requirement that such information be true and correct; a prospectus that is not amended to remain true and correct stands in violation of § 5(b). So prospectuses must be amended to reflect post-effective developments which make prospectus misleading in any material respect.

4. Critique. the securities laws are intended to serve to goals – full disclosure and deterrence of fraud - but Manor intertwines them, by making §11, which sets up a negligence std for liability for misstatements and omissions in the RS, superfluous. Under Manor, § 11 is replaced with a regime of SL allowing rescission under §12(a)(1) for misstatements and omissions in the RS.

d. §12(a)(2) Liability i. Applies to: exempt securities, registered securities sold by means of false

prospectus, FWPii. a) Any person who--

1. 2) offers or sells a security (whether or not exempted by §3, other than §3(a)(2) and §3(a)(14)),

2. by the use of any means or instruments of transportation or communication in interstate commerce or of the mails,

3. by means of a prospectus or oral communication (oral communication must relate to the prospectus),

a. which includes an untrue statement of a material fact, or b. omits to state a material fact necessary to make the statements

not misleading in the light of the circumstances under which they were made,

c. (the purchaser not knowing of such untruth or omission), and

4. who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,

5. shall be liable, subject to subsection (b), to the person purchasing such security from him, who may sue …

a. to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or

b. for damages if he no longer owns the security.iii. Loss causation

1. In an action described in §12(a)(2), if the offeror or seller proves that part or all of the amt recoverable under §12(a)(2) represents something other than depreciation in value of the subject security due to errors or omissions in that part of the prospectus or oral communication for which he’s supposedly liable, then such portion or amount, shall not be recoverable.

iv. Damages under 12(a)(2)1. Recovery of $$ paid + interest (-) income earned on the security, or2. Damages if security is already sold3. Note: PSLRA added §12(b), which allows D in §12(a)(2) actions to

show that loss was due to other factors not related to the misstatement.v. Elements (similar to those in Equitable Recission)

1. Misrepresentation of a material fact2. Culpability of seller

a. Seller can defend if can show he did not know or by exercising reasonable care could not have known

b. Reasonable Care –7th Cir. has held that UW must have actually performed investigations to use the “reasonable care” defense. But, SEC has stated this is not necessary; the “reasonable care” defense s/n/b as difficult to meet as the §11 “due diligence” defense

3. Reliance of purchasera. Purchaser need not show he relied, just that he did not know

the defectb. Some courts place a transaction causation reqm’t, such that the

defect had to have been instrumental in making the sale happen4. Loss causation

a. PSLRA adds §12(b) “loss causation” defense similar to §11 “negative causation” defense

vi. Possible Defendants1. Seller + Collateral Participants Acting for Value

a. §12(a)(2) has same language as §12(a)(1) – “Any person who offers or sells a security”

b. So, under Pinter, it covers 1) seller who passes title, 2) collateral participants who solicit purchasers for their own or the issuer’s benefit

2. Issuer : Issuer Liability under §12(a)(2) – Rule 159Aa. For purposes of §12(a)(2), an issuer is a seller, regardless of the

method of underwriting, if the securities are sold to the purchaser by means of a statutory prospectus

b. As for sales made by FWP, issuer only liable for communication prepared by or on behalf of issuer or used or referred to by issuer.”

c. So, issuer can’t argue wasn’t a seller just b/c the UWs who technically sold the securities

vii. SOL (SA §13)1. Suit must be brought w/in 1 yr after discovery of the defect, or after

discovery s/h/b made 2. In no event, more than 3 years after security was bona fide offered to

the publicviii. Information post-contract of sale not considered for purposes of 12(a)(2)

liability: information received by the investor after the contract of sale established, ie. final prospectus supplement in a takedown received post investment decision, does not count as disclosure to investor at point of sale for 12(a)(2) liability.

ix. 12(a)(2) only applies to public offerings (Gustafson)1. Gustafson v. Alloyd Co. (CB 507)

a. Facts: Gustafson was selling Alloyd, Inc. to Wind Point Partners. At closing time, Alloyd’s actual earnings were lower than had been projected in the contract, so buyers sought recession, claiming that the contract was a prospectus under §12(a)(2).

b. Issue: Was sales agreement a prospectus? Does 12(a)(2) apply at all? Does §12(a)(2)’s rescissory right reach private, secondary x-actions, on the theory that recitations in the purchase agreement are part of a prospectus?

c. Holding/Rationale: No, because the K was not a prospectus. Court begins with §10, which states that a prospectus must include the information in a RS. Since no one contends that a K must contain all info of the RS, the K can’t be a prospectus. **Thus, if ’33 Act is to be consistently interpreted, §12(a)(2) liability for a misleading prospectus can’t attach unless the alleged “prospectus” was req’d to be distributed in the 1st place (or unless there’s an exemption)

d. Moreover, §2(a)(10)’s definition of “prospectus” includes docs of “wide dissemination,” which this K was not. In sum, “prospectus” is a doc that describes a public offering of securities by an issuer or a controlling shareholder, which this K was not.

2. Bottom Line - §12(a)(2) only applies to public offerings, and offerings that would be a public offering but for an exemption.

3. Exempt Transactions – While these aren’t true “public offerings” Gustafson says §12(a)(2) liability still applies, because it would have been a public offering were it not for the exemption.

4. Oral Communications – Gustafson dicta suggests that §12(a)(2) liability attaches to oral communications only if they pertain to the prospectus.

X. Sarbanes-Oxley and NYSE Listing Standards: Board and Auditor Independencea. The Sarbanes-Oxley Act

i. July 2002. Act is implemented in SEC Regsii. Largely applicable to foreign issuers, with some exceptions

iii. Created Public Co Acctg Oversight Board (PCAOB) under SEC supervision, responsible for est’g auditing, QC, attestation & ethics stds for public co auditors. SOx §7211, CS 1935

iv. Audit Requirements, ’34 Act, §10A (CS 615). 1. Audits must cover: 1) controls in place to detect illegal acts, 2) to

detect related party x-actions & 3) evaluation of going concern status, 10A(a)

2. Prohibiting various types of non-audit services (§10A(g), CS 617)3. Requires Audit Comm. approval and disclosure for other non-audit

services, 10A(h)4. Audit partner rotation every 5 yrs & a 1 yr cool-off period before

certain members of the audit team may accept certain jobs w/the issuer (§10A(g), CS 617)

5. Audit firm shall report particular data to Audit Committee, 10A(k)6. Audit firm is selected and employed by the audit committee7. Non-compliance delisting8. Audit committee has $$ to pay audit firm or other advisers, 10A(m)9. Need to establish ombuds process for complaints and whistleblowers10. Response to Audit Discoveries: If auditor finds info that suggests an

illegal act has or may have occurred, the auditor should determine whether it’s likely to have occurred, and inform management and/or the audit committee. If no acceptable remedial action is taken, auditor should report to BOD. BOD must then file a notice with the SEC. If BOD does not, Auditor should resign, or notify the SEC directly. (§10A(b), CS 615)

v. Loans to executive officers and directors prohibitedvi. Disgorgement of of CEO and CFO compensation following restatement of

financial statementsvii. Rules for Attorneys, SOx §7245,

1. Requires SEC to establish rules for professional conduct for attorneys2. Enacted by SEC in 17 CFR 205.x,

viii. CEO and CFO certifications of financial statements. (404)1. For each periodic report, must certify:

a. That they’ve reviewed the report,b. That to their knowledge, the report contains no untrue stmt of

material fact,

c. That to their knowledge, the report fairly presents the financial condition and results of operations

d. That the officer is responsible for maintaining the firm’s internal controls and, amongst other things, has evaluated their effectiveness in the last 90 days, and notified the Audit Committee of:

i. “significant deficiencies” and “material weaknesses” in the internal controls, and

ii. any fraud, material or not, involving employees involved in controls

ix. Independence of the Audit Comm., S-Ox §301 (§10A(m) of ’34 Act, CS 618), §407

1. Independent directors only; may not be an “affiliated” person of the issuer or accept any consulting, advisory, or other compensatory fee from the issuer

a. Affiliate is “a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified,” Rule 10A-3(e)(1)(i), CS 849

b. The following will be deemed to be affiliates: an executive officer of an affiliate; a director who is also an employee of an affiliate; a general partner of an affiliate; & a managing member of an affiliate, Rule 10A-3(e)(1)(iii), CS 849

2. Authority over Auditor: BOD has authority to control selection, fees, & performance of outside auditor §10A(i)(1)(A), CS 617

3. Outside Advisers: Power to retain, eg. law firm, & compel funding, §10A(m)(5)-(6)m

4. Finance Expert: Must disclose whether any member of the Audit Comm is a finance expert (defined at Reg S-K Item 401(h)) & if not, why not. SOx §7265, CS 1959

a. Financial expert attributes: has…(1) an understanding of generally accepted accounting principles and financial statements; (2) experience in (A) the preparation or auditing of financial statements of generally comparable issuers; and (B) the application of such principles in connection with the accounting for estimates, accruals and reserves; (3) experience with internal accounting controls; and (4) an understanding of audit committee functions.

b. Safe Harbor: Audit committee’s fin. expert is not an expert for any purpose, incl. §11 liability under the ’33 Act. Such designation imposes no obligations or liabilities beyond those of a normal director. (Reg S-K Item 401(h))

x. Pro-Forma Financials1. Reg G: Whenever pro-forma financials are issued, issuer must provide

a comparison/reconciliation to the GAAP financial statements

2. Item 10(e) of Reg SK adopts similar reqm’ts when issuer is filing periodic reports w/SEC

b. NYSE Rule Chg: i. Amend certain provisions of §303A of the NYSE Listed Company

Manual (SS 109-132)ii. Scott thinks this is a bad way of making law: SEC essentially bullying SROs

into “independently” promulgating rules for independence, etc.iii. Independence: Series of bright line tests that directors must satisfy in order to

be eligible to be deemed independent1. General . BOD must determine director has no “material” relationship

w/the company, & disclose the basis of this determination.2. Employees . A director who is an employee, or whose immediate

family member is an executive officer of the issuer would not be independent until three years after such employment relationship

3. Direct Compensation . A director who receives, or whose immediate family member has received, more than $100,000 per year in direct compensation from the listed company [except for director and committee fees, compensation by an immediate family member as a non-executive employee] during any twelve month period within the last three years would not be independent

4. Auditors . A director who is affiliated with or employed by, or whose immediate family member is affiliated or employed in a professional capacity by a present or formal internal or external auditor is not independent until three years after the end of the affiliation or employment

5. Interlocks . A director who is employed or whose immediate family member is employed as an executive officer of another company where any of the listed company’s present executives serve on that compensation committee would not be independent until three years after the end of such service or the employment

6. Business Relationship . A director who is an executive officer or an employee, or whose immediate family member is an executive officer of a company that makes payments to, or receives payments from, the listed company which, in a fiscal year, exceed the greater of $1M, or 2% of such other company’s gross revenues would not be independent until three years after falling below such threshold [charities are not companies, but contributions of this scale must be disclosed]

iv. Non-management directors must meet in regular executive sessions without management

v. Nominating, audit and compensation committees must all have onlyvi. independent directors

vii. Audit Committee: min 3-person, all independent directors1. each member s/b financially literate2. Min 1 req’d to have acctg or related financial mgt expertise

viii. Every company must have an external audit function

ix. Each company must have disclosed corporate governance guidelines and a code of business conduct and ethics

x. Require CEO of each listed company to certify to NYSE each year that he is not aware of any violation of NYSE's corporate governance listing stds

xi. Controlled Companies: Exempts any listed company where >50% of the voting power is held by an individual, a group or another company from the reqm’ts that its board have a majority of independent directors, and that the company have nominating/corporate governance and compensation committees composed entirely of independent directors.

xii. Foreign Private Issuers: Permit NYSE-listed FPIs, to follow home country practice in lieu of the new requirements, with some exceptions

c. Auditor Independencei. Auditor Independence, SEC Regulation S-X, Rule 2-01 (principles-based

approach)1. Accountant is not independent if the accountant is not, or a reasonable

investor with all of the facts would conclude he/she was not, capable of exercising objective and impartial judgment. In considering whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client

2. Prohibited financial relationships (of auditor or immediate family member), no look back:

a. investments in an audit client or a material investment in a company in which the audit

b. company has an investment or which has a material investment in the audit client

c. investments in a company which can significantly influence or be significantly influenced by the audit company

d. loans to or from the audit client, financial relations with the audit client, e.g. deposits in a bank, insurance form the audit client (unless obtained prior to engagement)

3. Broad prohibited employment and business relationships4. Cannot provide non-audit services (does not include tax)5. Cannot charge contingent fee6. Partner rotations every five years (exempts small audit firms)7. Lack of knowledge of violation of independence requirements a

defense to liability if prompt correction of violation, and has a quality control system based on size and nature of practice

d. Economic Studies Examining Efficacy of Sarbanes-Oxleyi. Zhang (2005): examines market judgment as to whether SOX was net benefit

to s/hs, concludes that market did not like SOX because of abnormally high negative volatility in periods surrounding SOX legislation and enactment

1. severe problems with this event-driven study:a. which events do you choose?b. Stocks could have gone down b/c they thought Bush would

WEAKEN SOX, which they actually valued

c. i.e., so hard to actually pinpoint what the stock reaction meansd. also looks at overall volatility of market and not particular

companiesii. Governance Index Studies (G-scores):

1. Bhagat and Black (2002): no significant correlation between board independence and stock returns

2. Key study: Gompers, Ishii and Metrick (2003) find firms with strong shareholder rights, as measured by a 24 item G-index, have stock returns that are 8.5% higher than other firms

3. Not really relevant to SOX because G-indexes (see Brown and Caylor (2005), Table I), include many items that were unrelated to SOX, e.g. lack of anti-takeover protection

4. G-index factors with explanatory power: Bebchuk, Cohen and Farrell (2004)—staggered boards, limits to shareholder bylaw amendments, supermajority requirements for mergers and charter amendments, poison pills and golden parachutes (management entrenchment);

5. Brown and Caylor: staggered boards, poison pills, directors attend 75% of meetings or have valid excuse (measures interest, not independence), nominating committee composed solely of outside directors (NYSE), board guidelines in proxy statement, no option re-pricing within last three years, average options granted in last three years did not exceed 3% of shares outstanding

6. Association of governance factors with better returns does not necessarily show causality: Core, Guay and Rusticus (2005), (SS 103)—firms with poor corporate governance, based on G-24 index, have worse operating results, but this does not surprise the market. Analyst forecast errors no different for good/bad firms (analysts know about governance), nor does market react to earnings announcements differently for good/bad firms—so better returns must be due to something else.

XI. Sarbanes-Oxley: Internal Controls and Duties of a Securities Lawyera. Internal Controls (SOX 404)

i. (a) each annual report is to contain an internal control report, which shall:1. state management’s responsibility for establishing and maintaining

adequate internal control over financial reporting of the company, AND

2. include a management assessment of the effectiveness of such controlsii. (c) each registered public accounting firm that prepares the audit report for the

issuer shall attest to and report on the management assessment (i.e., the auditor must verify the statements made by management)

b. Definition of Internal Controls (15d-15(f)): i. The term internal control over financial reporting is defined as a process .

ii. . .to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in

accordance with generally accepted accounting principles and includes those policies and procedures that:

1. (1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer;

2. (2) Provide reasonable assurance that transactions are recorded as necessary to [permit proper accounting] and that receipts and expenditures are being made only in accordance with the authorizations of management and the directors of the issuer;

3. (3) Provide reasonable assurance regarding prevention or timely detection of unauthorized [transactions] . . .that could have a material effect on the financial statements.

c. CEO / CFO Certification: i. Must certify they have fulfilled the obligations of 404, (§302 / §7241(4)-(6),

CS 1953)1. Eg. That the officer is responsible for maintaining the firm’s internal

controls and, amongst other things, has evaluated their effectiveness in the last 90 days, and notified the Audit Committee of:

a. “significant deficiencies” and “material weaknesses” in the internal controls, and

b. any fraud, material or not, involving employees involved in controls

2. Material Weakness is “a significant deficiency, or combination significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.” (PCAOB Auditing Standard No. 2, March 9, 2004)

3. “significant deficiency” is “a control deficiency, or combination of control deficiencies, that adversely affects the company's ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company's annual or interim financial statements that is more than inconsequential will not be prevented or detected.” (PCAOB Auditing Standard No. 2, March 9, 2004)

ii. Criminal liability for knowing (up to 10 yrs) or willful (up to 20 yrs) violations of certification requirements, SOx §906

iii. Reg SK, Items 307, 308 implement these certificationsd. Costs of SOX 404:

i. Total direct costs (2004): total $15-20 billion, $3 - $5 million per large company

ii. Greater EPS (earnings per share) impact on smaller companies (same controls and less revenue)

iii. Expected to decrease by 30% – 40% in succeeding years, but still very significant

iv. Indirect costs may be far more significant

1. Management opportunity cost2. Change business decisions to reduce need for controls3. Competitive impact on U.S. capital markets: foreign and4. private

e. Benefits of SOX 404: Difficult to Quantifyi. Prevention of Frauds through better controls:

1. Bryan and Lilien study: its the small firms that have “material weaknesses”—represent only 1.28% of market value of S&P 500

2. Use restatement impacts as benchmark: (2004) restatement frequency of 5% of companies, with negative market impact of -2%, means impact of 10 basis points (.001) of total market capitalization of $17 trillion, or $17 billion—but most restatements not due to failure of internal controls, e.g. accounting changes, tax miscalculations, so true figure is probably 30% of this

ii. Restore Investor Confidence: 1. Nicolaisen, former Chief SEC accountant: “Representing to the world

that a company has in place an appropriate control system, free of material weaknesses, that gathers, consolidates, and presents financial information strengthens public confidence in our markets and encourages investment in our nation’s industries. If that’s the case then its worth it, and it is absolutely critical that we get the internal control requirements right.”

f. PCAOB Policy Recommendations to Decrease Costs of SOX 404i. Auditors should:

1. Integrate audits of internal controls with audits of financial statements2. Tailor audits to risks facing individual clients (small v. large)3. Use a top-down approach to examine company level controls and drill

down where there are problems4. Use the work of others (internal auditors/consultants)5. Engage in direct and timely communication with audit clients

ii. SEC continues to defer application of 404 to small companies (and also new listings and foreign companies)

iii. But these recommendations are incredibly vague (albeit, principles based) and don’t shield auditors from liability

1. Could make these guidelines more specific2. Could offer safe-harbors to certain reliances as above

a. **Have them monitor the internal auditors3. Why are auditors beign so excessive?

a. They can’t get indemnified – they’re afraid of liabilityb. They want to get paid!!!c. Also concentration of 4 acct firms gives them leverage on price

iv. Reducing liability of auditors under SOX 4041. Liability under 10b-5 or some other general fraud statute2. What can be done? Cap damages.

a. But go back to basic BPL formula: burden of loss as compared to probability of loss times times the magnitude of loss

b. Damages arent the only deterrent: reputational damagesc. ALSO: texas juries don’t use BPL to calculate damagesd. So by capping damages, we’re trying to calibrate more

appropriate damges3. But what is the CAP??

a. Some absolute figure?b. Percentage of net worth? (hard to do with audit firms)c. Should it vary based on type of behavior? i.e. low cap for

negligence to high cap for willful fraud4. Another solution: do an audit every three years5. Or, do random audits (like drug testing)

a. Might cause market problems in terms of information: b/c market may have trouble comparing companies

g. Duties of a Securities Lawyer (SOX 307)i. Commission must promulgate rules:

1. requiring an attorney to report evidence of a material violation of securities law, breach of fiduciary duty, or similar violation by the company or any agent thereof, to the chief legal counsel or CEO; AND

2. if the counsel or officer does not appropriately respond to the evidence (adopting, as necessary, appropriate remedial measures or sanctions with respect to the violation), requiring the attorney to report the evidence to the audit committee of the issuer, or to another committee of the board comprised solely of outside directors, or to the entire board of directors

ii. NO PRIVATE RIGHT OF ACTIONiii. Duty to report evidence of material violation by all attorneys practicing

before the Commission 1. Transacting any business with the Commission…2. Representing an issuer in a Commission administrative proceeding or

in connection with any Commission investigation…3. Providing advice in respect of the US securities laws or the SEC’s

rules or regulations there-under regarding any document that the attorney has notice will be filed…with the Commission…

4. Advising an issuer as to whether information or a statement, opinion, or other writing is required under the US securities laws or the SEC’s rules or regulations thereunder to be filed with, or submitted to, or incorporated into any document that will be filed with or submitted to the Commission…

5. Excludes attys who:a. Conduct the above activities in a context other than atty-client

provision of legal svcs, orb. Are non-appearing foreign attorneys

6. NOTE: when representing an issuer, represent only the issuer and not individuals (205.3(a)).

7. BUT do not want to be able to allow issuers to circumvent process by having only directors hire personal lawyers to provide

securities advice – 205.2(g): you represent issuer if you advise relating to legal services of issuer regardless of employment by another

iv. Evidence of a Material Violation:1. credible evidence based upon which it would be unreasonable, under

the circumstances, for a prudent or competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur…

2. SEC comment: this formulation adopts an objective standard, yet also recognizes that there is a range of conduct in which an attorney may engage without being unreasonable

3. “reasonably likely”: lower standard than actual knowledge of material violation; “must be more than a mere possibility, but need not be ‘more likely than not’”

v. Material violation isn’t restricted to securities laws 1. Must report material violation of any US federal or state law2. Makes sense b/c even if not securities related, if its material, it will

have a material impact on the company if not disclosed etc.vi. ABA Model Rule 1.13(b)

1. (b) If a lawyer for an organization knows that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization…then the lawyer shall proceed as is reasonably necessary in the interest of the organization…

2. Unless the lawyer reasonably believes that it is not necessary in the best interests of the organization to do so, the lawyer shall refer the matter to higher authority in the organization including, if warranted by the circumstances, to the highest authority that can act on behalf of the organization

3. (c) [When the highest authority]…fails to address in a timely and appropriate manner an action or refusal to act that is clearly a violation of law and…the lawyer reasonably believes that 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 that the lawyer reasonably believes necessary to prevent substantial injury to the organization.

vii. Noisy Withdrawal SEC Proposal still not accepted:1. modified proposal would require disclosure of withdrawal by attorney

by issuer which would then disclose that to SEC2. Still problematic: private advice of lawyer to company now becomes

public, which may violate codes of professional responsibilityXII. Definition of a Security

a. Definitions:i. ’33 Act (§2(a)(1)): [unless the context otherwise requires,] security means

any note, stock, treasury stock, security future, bond, debenture, evidence of

indebtedness, profit-sharing agreements…or, in general, any interest or instrument commonly known as a “security”…

ii. ’34 Act (§3(a)(10): [unless the context otherwise requires,] security means any note, stock, ….but shall not include currency or any note, draft, bill of exchange or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months…

b. Novel or irregular devices reached by act if widely offered or dealt in under terms or courses of dealing which established their character in commerce as “investment contracts” or as “any interest or instrument commonly known as a security”. Joiner Leasing (1943) (holding offering and sale of an assignment of oil leases as security)

c. Howey Test for Investment Contracts:i. Briefly stated: An investment contract for purposes of the 33 Act means a K,

transaction or scheme whereby:1. a person invests his money, 2. in a common enterprise, and 3. is led to expect profits,4. solely from the efforts of the promoter or a third party

ii. Facts: Involved the offering of units of a citrus grove development coupled with a contract for cultivating, marketing and remitting the net proceeds to the investors

iii. Howey Test:1. Investment of Money (cash or non-cash)2. Common Enterprise among investors

a. Vertical Commonality: Investor(s) has(have) a common interest w/the mgr of his investment

i. emphasizes the relationship between the investors and the promoter

ii. Turns on whether promoter’s activities are the critical factor in the investment success/failure

iii. May exist even tho there’s no pooling of investors’ funds or interests

iv. May arguably exist even if there is only a single investor

v. Broad vertical commonality- requires only a connection between the efforts of the promoter and the collective successes or losses of the investors

vi. strict vertical commonality- requires a direct relationship between the success (as opposed to the efforts) of the promoter and that of the investors

1. this requires them to share the risks of the venture

b. Horizontal Commonality: Multiple investors have a common enterprise amongst them

i. more restrictive approach. Covers fewer transactions.ii. requires a pooling of investors’ funds

iii. can have fixed or variable returns, but usually involves a pro rata distribution

3. is led to expect profits a. Which come from earnings of the enterprise, not just inflow of

add’l investor $$4. derived solely from the efforts of others

a. not really “solely,” some investor participation is allowedi. “Efforts of others” just have to be undeniably

significant/predominate, or be the essential managerial efforts that affect the enterprise’s failure/success (Turner and Koscot, CB 38)

ii. literal approach of Howey test would frustrate the remedial aspects of the securities acts. Seller could condition the deal on a minimal mgt by the investor, and thus avoid Howey

b. Franchise or distributorship arrangements generally require a level of activity by investors to defeat classification as investment contracts

i. but, if the optional nature of a sales agency agreement is illusory because the franchisees, as a practical matter, are not in a position to sell the product themselves, it can be an investment contract, SEC v. Acqua-Sonic Products Corp., CB 40

c. Timing of efforts of others is relevant to the investment K analysis, SEC v. Life Partners, CB 40

i. the value of the promoter’s efforts was already in the purchase price of the investment, b/c promoter was not expected to make further efforts to affect the investment outcome

ii. so, the need for federal securities regulation was greatly diminished

iii. the administrative functions (making sure insurance premiums were paid, overseeing the disbursement of funds) that Life Partners would still have to perform received less weight than if they still had to perform entrepreneurial functions

iv. the viatical settlements marketed by Life Partners were not securities b/c the profits did not depend predominately on the efforts of Life Partners

d. Risk-Capital Test - alternative test employed by some state courtsi. risk- a security will not exist unless capital provided by investors is at

substantial risk1. if the risk is minimal b/c of the issuer’s strong balance sheet or

adequate collateralization, the likelihood that an investment contract will be found is lessened

ii. capital- not used in a narrow sense, but rather the economic capital which is placed subject to the risk of loss through operation of the scheme in question

iii. differences from Howey1. does not necessarily require common enterprise2. avoids requirement that profits be derived “solely” from the efforts of

otherse. Private commercial transactions not classified as securities if:

i. Personally and uniquely negotiatedii. Not widely promoted

iii. Marine Bank: COD not a security (otherwise protected by banking laws)f. Consumption v. Investment

i. Purchase of “shares” in subsidized housing co-op not securities because the purchase was made not with an investment intent but instead an intent to reap a gain from the efforts of others. Forman.

g. Investments with fixed returns qualify as securities; indeed investments pitched as low risk may be most enticing to unsophisticated investors most prone to securities fraud. Edwards. (note that sale-leasebacks here might not have been securities had they been lent out by a commercial bank)

h. Sales of all or substantially all of the stock in closely held corporations not exempt from the federal securities laws. Landreth Timber (stock here possessed all the usual characteristics of a stock in acquisition of a company)

i. Howey test only applies to investment contracts, not other enumerated items in definition of security

ii. Would have FAILED howey test here – not an investment but a full purchase!iii. Implication: securities laws protect acquisition of 100% of a company or

asset – BUT do we really need to protect in those situations??i. Partnerships as Securities

i. not addressed directly in the statute, so issue is usually presence of an investment contract and whether investors are dependent for their profits on the efforts of others.

ii. Few cases actually do treat P-ship interests as securities.1. Plaintiffs have a better chance if they’re LPs than if they’re GPs2. Cts tend to see passive LPs as parties deserving Securities Laws

protections. And there’s latitude that actually allows LPs a relatively broad range of participation before they lose these protections

iii. Partnership interest is a security if party can establish: (Tucker)1. no legal control;2. no capacity to control; OR3. no practical control

iv. Steinhardt: LP had meaningful control: veto power, removal of GP, material actions required its appoval not a security

j. Debt Securities (Notes)i. Reves Family Resemblance Test:

1. Begin with presumption that any note is a security, unless falls into an exception

2. Then look at list of notes that are obviously not securities

a. Issuer can rebut presumption that a note is a security if it can show that the note bears a strong family resemblance to an item on the list of exceptions

b. Eg. Notes in a consumer financing, notes secured by a mortgage on a home, ST note secured by a lien on a small biz or some of its assets, ST notes secured by assigned ARs

3. If note isn’t sufficiently similar to an item on the list, or for new transactions, the decision rests on the factors that helped create the list:

a. Motivation of parties: investment v. consumptionb. Plan of distributionc. Public expectationsd. Risk reducing factors, eg. Collateral or alternative regulation

ii. Facts of Reves: 1. Demand notes issued by a farmer’s co-op to members and non-

members alike, at variable rates of interest, payable on demand2. Notes are unsecured but touted as “safe and secure”3. Co-op files for bankruptcy, defaults on notes4. Noteholders sue auditor

iii. Why were the notes in Reves securities? 1. Term could be more than 9 months2. The demand note doesn’t resemble items on list3. Factors suggest this

a. Motivation: conceived as an investment in a biz enterprise rather than as a purely comm’l x-action

b. Plan of distribution: notes were offered & sold to broad segment of the public

c. Public perception: advertisement for notes characterized them as “investments”

d. Risk-reducing factors: noneiv. Short-term exemption of ’34 Act only applies to high quality commercial

paper. Wallenbrock1. SEC wants to protect investors here, so will only exempt short-term

notes that are high quality2. here it was a pyramid scheme marketed to retail investors3. qualifies as a security under the Reves test

k. Reason for Separate Tests for Equity and Debt Securities: i. Equity requires the efforts of others, whilst debt is purely financial

l. Conclusions about what is a securityi. Root of this is investor protection: language of statutes is often manipulated

to achieve this resultii. Hard to justify two tests: howey v reves

iii. Exemptions treated differently under ’33 and ’34 acts1. Exempt securities entirely outside the coverage of 34 act, anti-

fraud provisions as well as ongoing reporting

2. Exempt securiites under ’33 act may only be excluded from registration (really a transaction exemption) and not the 12(a)(2) antifraud provisions: does this remainig coverage make sense???

XIII. Intrastate Offering Exemptiona. §3(a)(11) exempts:

i. “Any security which is:1. a part of an issue 2. offered and sold only to persons resident within a single State or

Territory, 3. where the issuer of such security is:

a. a person resident and doing business within, orb. if a corporation, incorporated by and doing business within,

4. such State or Territoryb. Despite placement in Section 3 (Exempt Securities), 3(a)(11) considered a

TRANSACTION EXEMPTIONc. Scope of Exemption

i. Concept1. Must sell exclusively to residents of single state- usually for local

financing of local business via local investment2. “Part of an issue”- looks to facts on whether part of plan or program;

so no exemption is combined with different parts of single issue where some sold to nonresidents; voids all of intrastate exemption

ii. Doing Business in State1. Substantial operational activities (not just bookkeeping, etc.)2. Can’t rely on exemption if used for new business outside of state and

unrelated to business locally conducted3. Not valid for series of corporations in different states where they

constitute single ventureiii. Residence within State

1. Residence is more than presence2. Formal representations of residence and agreements not to resell to

nonresidents are not enough w/o more3. If offering large enough from start, questions if it will be successful as

local offering4. Secondary offering by controlling person in state may be made in

reliance on exemption if would be available to issuer in primary offering; if corporation is in state, individual seller need not be resident

iv. Resales1. Only get exemption if entire issue is to residents; if sell to nonresidents

or resales to nonresidents, lose exemption2. Needs to “come to rest” in state before resale- time between sale

and resale a primary factor; needs to not be part of primary distributiona. Statutory Test: depends on whether purchaser bought with

intent to invest, e.g., hold for substantial timei. Resale within 1-2 years suspect, burden of proof on

seller

ii. investor change of circumstances may shift burdenb. Inference even stronger if short time if party is a broker (although broker can be out of state but must sell to residents)

v. Use of mails and facilities of intrastate commerce- can use intrastate modes of communication

d. Notes, Questions and Policyi. Premise- Question whether state regulation is really adequate and whether

investors are more familiar with company just because it’s in-state (esp. with large states and complex and national businesses)

ii. Nonresident sales- even if by accident or to small number, voids exemption

iii. Measuring Business Activity in state- “substantial operational activities test”; Chapman says must be “predominant”; difference?

iv. Secondary offerings- Release says control person can do as part of secondary offering; SEC v. Tuchinsky says rule does not exempt secondary sales, and some SEC interpretations say primary must also have been qualifying under exemption

v. Coming to rest- SEC issues Minnesota Release because of epidemic reselling of intrastate offerings to nonresidents in MN- warned exemption is not available to issuers if as a result of a chain of transactions, process of distribution is not completed prior to time securities are acquired by nonresidents

1. Release 4434 issued shortly thereafter softened this and said that securities that have actually come to rest in hands of residents who purchase without a view to resales to nonresidents may be resold without voiding exemption

vi. Resales- uncertain when securities “come to rest”; Rule 147, infra, provides 9 month holding period; previous rule of thumb was one year- but still ambiguous (NOTE: b/c it’s a transaction exemption, unregistered resales VOID the exemption)

e. Rule 147 Safe Harbori. Rule 147: offers and sales made in accordance with 147 provisions qualify for

3(a)(11) exemption1. Introductory notes

a. Refers to 3(a)(11)b. Rule so integration as above

2. Part a- Transactions Covered- transactions within 3(a)(11)3. Part b- Part of an Issue (Integration Safe Harbor)

a. Can’t combine with exemptions from Section 3 or 4(2) OR Pursuant to registration statement within 6 months of 147 exemption

b. Factors for integration (Release 4434): are/do the offeringsi. Part of a single plan of financing

ii. Involve issuance of same class of securityiii. Made at same timeiv. For the same type of consideration

v. Made for same general purposec. Integrated if same class of securities made by issuer at or about

the same time4. Part c- Nature of Issuer

a. Resident of state ifi. Incorporated or organized under that state if it’s

corporationii. It’s principal office is located in state but a non-

corporation organizationiii. It’s principal resident is there if individual

b. Doing Business in state if: (Triple 80 Test)i. 80% of gross revenues derived from that state (for

approximately last fiscal year)ii. 80% of assets in state

iii. 80% of issue proceeds to run operations, provide services, or purchase assets in that state

iv. AND principal office in state5. Part d- Offerees and Purchasers; Person Resident- is a resident for

offeree or purchaser if:a. Corporation, partnership, organization has principal office in

stateb. Individual has principal residencec. Business organization organized specifically to acquire part of

an issue must have all of its beneficial owners in a state6. Part e- Limitation of resales

a. 9 month period from last sale by issuer before can sell out of state

b. Can always sell in statec. Why can you resell as unrestricted? b/c those securities are

exempt securites (b/c they fall under Section 3)7. Part f- Precaution against interstate offers and sales

a. Issuer shalli. place on certificate noting securities are unregistered

and subject to intrastate limitations from eii. issue stop transfer instructions to transfer agent

iii. obtain written representation as to resident’s in-state residence

b. Maintain the above for new certificates and will disclose the above restrictions on resale regarding any offers to sell

ii. Notes and Questions1. Rarely will get no-action letter if going intrastate outside of Rule 1472. Nothing in 147 about disclosure to investors3. Who’s allowed the exemption? Note to 147 indicates only for issuer,

but Release 5450 says it may be available to affiliates as wella. But loose requirements for underwriters who can sell on a best

efforts or firm commitment basis

4. May lose 147 safe harbor even if through an “innocent and immaterial” deviation (unlike Regs D and A)

5. Defense of good faith compliance (19(a)) ’33 act: Protected from liability if you comply with a rule that is change or is found invalid

6. Ideas for reform in 1996 Report on the Task Force on Disclosure Simplification (none adopted)

a. Development of “substantial compliance” provision so can’t inadvertently fall outside 147

b. Focus of exemption should be on purchasers, not offereesc. allow sales to investors who spend substantial amounts of time

in more than one stated. relax 9 month resale period to 6 or 3 monthse. “doing business” test to be reduce to 50% or eliminated in

favor of predominance or substantial operation test, and get rid of “use of proceeds” test entirely

f. Allow new Section 3(b) that allows “local” transactions across state lines in major metropolitan areas (eg Tristate area) or within prescribed distance of issuer’s principal place of business

XIV. Private Placement Exemption and Regulation Da. Private Offering Exemption: § 4(2): Provisions of Section 5 shall not apply to

transactions by issuer not involving a public offeringi. Increasing Importance of Private Markets Today

1. Public equity issues are more important than private equity, 18T v 4T2. But if you combine everything, debt and equity, more is raised private

than public, private are 69% of the whole.3. Private issuance of securities is VERY important in the US these

days…its probably accelerated dramtically since then.4. Private equity cpaital commitments stlil remains a small portion of

total pubilc market cap, we’re talking about around 2-5%5. Going private transactions as % of public takeovers: has risen from

2.2% in 95 to about 25% todayii. What is a private offering?

1. Considerations:a. Sophistication (5th and 8th Circuits de-emphasize this)b. # of offerees(as this number increases, higher burden of proof

on issuer to show all offerees had requisite access)c. Access to infod. Disclosure of info (safest to make those required by Schedule

A of the 1933 Act)e. Insider status / relationship to issuerf. Size and manner of offering

2. Ralston: Exemption applies when offerees are able to fend for themselves

3. Doran Test (today): Sophistication plus access or disclosurea. sophistication of offeree, plus:

i. registration statement quality DISCLOSURE; orii. effective ACCESS to such information

iii. Resale1. Critical question- whether any of the purchasers acquired the securities

with a view to their distribution, rather than as an investmenta. A determination that supposed investors were actually acting as

conduits in a public offering will retroactively negate the validity of the original transaction as a private placement

2. Issuers commonly take three steps to avoid thisa. 1) Require purchasers to sign statements of investment intentb. 2) Inscribe securities to disclose that they are unregistered and

a transfer may take place only if specified conditions are satisfied

c. 3) Put into effect stop-transfer orders instructing the transfer agent not to process any transfers of restricted securities without the consent of the issuer

b. Regulation Di. General:

1. Rules 504 and 505 were promulgated on the basis of § 3(b) of the 1933 Act, which authorizes the SEC to develop exemptions covering offerings up to $5 million in amount when registration is not necessary to protect the public interest or investors.

2. Rule 506 represents a nonexclusive safe harbor for the private offering exemption of § 4(2).

ii. Rules:1. Rule 506

a. No Limitation on Amountb. May sell to unlimited AIs and < 35 non-AIsc. Disclosure and sophistication requirements for non-AIs

2. Rule 505 a. Up to $5Mb. May sell to unlimited AIs, < 35 non-AIsc. Only disclosure (not sophistication) requirement for non-AIs.d. Bad boy disqualifier

3. Rule 504 a. Up to $1Mb. May sell to anyonec. No disclosure or sophistication requirementsd. Solicitation and resale depend on state law.

iii. Economic analysis of the structure of Regulation D1. sliding-scale structure is sound in theory, but2. are the dollar thresholds properly set?3. they should be indexed for inflation4. cost of regulating small business offerings through 504 may exceed the

benefits and justify an unconditional small offering exemptioniv. Accredited Investors -

1. Not included when calculating total number of investors2. Important in determining the disclosure obligation of 505, 5063. Rule 501(a) – definition

a. Financial institutionsb. Pension plansc. Venture capital firmsd. Corporations and other organizations exceeding a certain sizee. Executive Insiders of the issuerf. Natural persons with wealth or income exceeding

i. Net worth > $1 million; ORii. Annual income > $200,000 (of $300,000 incl. spouse)

for each of the last 2 yrs if the current year’s income is likely to be above this level

4. NOTE: issuer needs only to reasonably believe investors falls under above categories

5. Why consider wealtha. Focus is the ability to bear the risk of loss with this set-upb. small issuers who are unable to attract the interest of AIs have

to deal withi. increased disclosure burdens

ii. if under 506, sophistication requirements6. Concerns:

a. Liquidity – Non-liquid assets (eg. home) factor in to net wealthb. Honesty – Is the supposed AI providing accurate info? Absent

red flags, issuer not req’d to audit AI’s supposed assets.v. Sophistication Standard of Rule 506

1. To enjoy Rule 506 safe harbor, issuer must offer evidence of their reasonable belief as to the nature of each purchaser. Mark v. FSC Securities Corp. (6th Circuit, 1989) (LP interests in horse investments sold)

a. Issue : Did offering fall w/in private placement safe harbor of Rule 506?

2. Sophistication Requirement: Rule 506 requires either:a. Each non-AI, alone or w/a rep, have such knowledge and

experience in financial and business matter to be able to evaluate the merits and risk of the prospective investment, or

b. The issuer reasonably believes this is the casec. [505 and 504 do not impose this reqm’t]

3. FSC didn’t offer any completed questionnaires prove this was the case, so didn’t get the exemption

4. Purchaser Representatives a. Definition of Purchaser Representative, 501(h): (h) "Purchaser

representative" shall mean any person who satisfies all of the following conditions or who the issuer reasonably believes satisfies all of the following conditions:

i. (1) Is not an affiliate, director, officer or other employee of the issuer . . . except where the purchaser is . . .[a] relative of the purchaser representative by blood, marriage or adoption and not more remote than a first cousin;

ii. (2) Has such knowledge and experience in financial and business matters that he is capable of evaluating . . .the merits and risks of the prospective investment;

iii. (3) Is acknowledged by the purchaser in writing . . . to be his purchaser representative in connection with evaluating the merits and risks of the prospective investment; and

iv. (4) Discloses to the purchaser . . . any material relationship between himself or his affiliates and the issuer or its affiliates.

vi. Solicitation 1. Rule 502(c) must be satisfied for Reg D exemptions to apply

a. Rule Text: “Except as provided in Rule 504( b)( 1), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising …”

b. Rule 504(b)(1) : States that the prohibitions on general solicitation and advertising (Rule 502(c)) and the limitations on resale (Rule 502(d)) do not apply to 504 offers and sales if they’re made:

i. Exclusively in states w/robust blue sky disclosure laws and the offers/sales are made in accordance w/those laws

ii. In a state w/robust blue sky disclosure laws and the offers/sales are made in accordance with those laws and disclosure docs are delivered to all purchasers, or

iii. Limited to AIs, in accordance with state laws that then allow general solicitations

2. Examples: advertisements, articles, notices, seminars/meetings whose attendees have been invited by any general solicitation or general advertising WILL VIOLATE 502(c)

3. Safe harbor: publication by an issuer of a notice in accordance with Rule 135c

vii. Case comparisons1. Easy cases: Mass mailings are general solicitations

a. In the Matter of Priority Access, Inc (Release No. 33-7904) – 2 million spam emails attempting to attract investors = solicitation

b. Johnston v. Bumba (ND Ill. 1991) – 2,500 mailings re: offering = general solicitation or advertising

2. Tougher case: Quasi-targeted mailing still a general solicitation

a. In the Matter of Kenman Corp. (SEC, 1985) – information about offerings sent to six groups of people: prior purchasers, executives of Fortune 500 firms, people who had invested $10,000 before with other issuers, physicians in California, and selected individuals from an industrial directory; HELD: general solicitation, no exemption

3. Dispositive Factor: Pre-existing relationship b/w issuer and offereea. Definition: must be sufficient to make issuer aware of offeree’s

financial circumstances and sophistication; looks at substance/duration

b. Policy: want issuers/reps to be able to evaluate suitability of offerees as purchasers

i. Concern for offerees is rooted in §4(2), which is foundational here, at least for 506

4. B/D can provide the pre-existing relation b/w issuer and offeree5. E.F. Hutton No Action Letter (1985) – Questionnaire can satisfy pre-

existing relationship test when prequalification is based on: investment objectives, net worth, income, sophistication, and history of investments; no need for prior investment with broker

a. BUT relationship must be est. PRIOR TO time B/D began work on the Reg D offering

b. Cannot offer securities that the firm was offering or contemplating offering at time of the questionnaire

6. Internet solicitations/pre-qualificationsa. Release No. 33-7233 (1995) – generally placing private

offering materials on web sites “would not be consistent with the prohibition against general solicitation or advertising.”

b. IPONet No Action Letter (1996) – online information can be distributed re: offerings if:

i. online questionnaire allows broker to determine whether the investor is accredited [under 501a] or sophisticated [for 506]

ii. the broker verifies the information provided by the investor, and

iii. the investor is given password access to page where offerings posted subsequent to the investor’s registration are listed

7. Release No. 33-7856 (2000) – reinforced IPONet practices, but expressed concerns over self-certification by investors by merely checking a box, and non-broker-dealer websites that pre-qualify investors and then pass them off b/c both don’t connect well with policy of pre-existing relationship

viii. Rule 135c Safe Harbor1. Adopted b/c issuers needed to be able to convey some information

about their offerings to inform existing shareholders of change in business/direction

2. Cannot be used to “condition the market” for the offering3. Only limited information allowed under 135c:

a. name of issuer, b. basic terms of securities offered, c. brief statement of the manner and purpose of the offering d. without naming the underwriters or price

ix. Calls for Reforms1. Problems: (1) hardship on small issuers w/o pre-existing relationships;

(2) focus on offerees not purchasers; (3) uncertainty in communication2. Although the SEC has looked into it & the ABA Business Law Section

has urged elimination of the prohibition on general solicitation, the SEC has not changed

x. Aggregation 1. Rule 504 and 505 limit the total offering prices within a 12 month

perioda. Rule 504b2 = $1 millionb. Rule 505b2 = $5 million

2. Calculating the cap:a. Offering price of all securities sold under Rule 504 or Rule

505 +b. Offering price of all securities sold w/in the previous 12

months in reliance on any §3(b) exemption – Rule 504, Rule 505, Reg A, Rule 701 +

c. Offering price of all securities sold in previous 12 mos. in violation of the §5 registration reqm’ts

3. Text of Rule 505b2: “The aggregate offering price for an offering of securities …shall not exceed $5,000,000, less the aggregate offering price for all securities sold within the twelve months before the start of and during the offering of securities under this section in reliance on any exemption under section 3( b) of the Act [504 and 505] or in violation of section 5( a) of the Act.”

4. Calculating value: cash is besta. If 50% cash & 50% other, take 2 * Cash = 100% value of

offering (Rule 501c)b. If all non-cash, determine by bona fide sales of the

consideration or “FV using accepted standard”5. Timing: 12 months + offering period

a. Aggregate for 12 months prior and for the period in which offering is open (closes loophole of multiple offerings at the same time after a year waiting)

xi. Disclosure 1. Governed by Rule 502b

a. Depends on the size of the offering and nature of issuerb. Policy balance between providing investor protection (via

mandatory disclosure) and purpose of rules 505 and 506

(permitting small issuers to raise capital in a cost-effective way)

2. Rule 504 Offerings: No disclosure req’d3. Rule 505, or Rule 506 Offerings

a. If sell only to AIs, no disclosure req’db. If sell to any non-AI, must disclose to all non-AIs and

preferably to AIs tooi. If a reporting company, must provide ’34 Act filings

ii. If a non reporting company, must disclose 1. Non-financial info = RS if offering is $5M+, or

Reg A offering if < $5M2. Financial information

a. < $2M – balance sheet audited and dated within 120 days

b. $2M <> $7.5M – audited financial statements (but some breaks)

c. > $7.5M – extensive/full audited financials

iii. Non-AIs are entitled to any info given to AIsc. AIs and Non-AIs entitled to ask questions

xii. Limitations on Resale 1. Governed by Rule 502d2. NO TIMING CURE LIKE WITH INSTRATE!3. Text of Rule: “Except as provided in section 504( b)( 1), securities

acquired in a transaction under Regulation D shall have the status of securities acquired in a transaction under section 4( 2) of the Act and cannot be resold without registration …” and further exemption

4. Rule Continued: “The issuer shall exercise reasonable care to assure that the purchasers of the securities are not UWs w/in the meaning of §2( 11) of the Act, which reasonable care may be demonstrated by the following:

a. Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons;

b. Written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and

c. Placement of a legend on the certificate or other doc that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities.

5. Closes loophole that would allow issuers to use private offering and then resell immediately

xiii. Integration (CB: 324-332) 1. Offering Integration Governed by Rule 502a

2. 6 Mo. Bright Line: “… Offers and sales that are made more than six mos before the start of a Reg D offering or are made more than six months after completion of the Regulation D offering will not be considered part of that Regulation D offering, so long as during those 6 mo periods there are no offers or sales of securities …”

3. If there is another offering within six months of the Reg. D offering, the following factors will determine whether the offering will be integrated (from Release No. 33-4552):

a. Part of a single plan of financingi. May turn on intent of issuer since plan presupposes

intent (Livens v. William D. Witter, Inc., D. Mass. 1974)ii. May also just be combination of other 4 factors

(Property Inv. No Action Letter, 1972)b. Issuance of the same class of securities

i. Generally debt not integrated with stock (SBT Corp. No Action Letter, 1980)

ii. More subtle differences like maturity and interest rate for debt can be enough (SEC v. Dunfee, W.D. Mo. 1966)

c. Sales made at or about the same timei. 6 month lapse creates rebuttable presumption against

integrationii. 1 year lapse may make the presumption irrebuttable

d. Same type of consideration giveni. Since most offerings involve cash consideration, the

fact that two offerings both give cash consideration is not a factor for integration (LaserFax No Action Letter, 1985)

ii. Non-cash consideration of the same type increases likelihood of integration

e. Made for the same general purposei. May be same as the first factor (single plan)

ii. Donohoe v. Consolidated Operating & Prod. Corp. (7th Cir. 1992) = best case

1. “suggests a level of generality to the integration analysis” – that each partnership in the case was to drill for oil was enough

2. BUT: “each project was designed to stand or fall on its own merits” and “turnkey price was fixed” so “savings were not passed on to the partnership” & court did not integrate

xiv. Critics:1. Bradford, 1996 Emory LJ article:

a. Doctrine is ill-defined (factors listed, but no explanation/clarification)

b. Uncertainty of 5 factor test in application

c. Costly both to administer by SEC and to comply with via private legal costs

d. Chilling effect on issuers b/c of risk of integration2. Campbell, Ky LJ article: call for complete elimination of integration

doctrine3. Committee Recommendation: extend concept of Shelf offering to Reg

D – allow WKSIs, once registered to do as many of these as they wantxv. Issuer Integration under SEC v. Murphy (9th Cir. 2001)

1. Definition: offerings by ostensibly distinct issuers are integrated as one issuer

2. Applied in Murphy to get to company (Intertie) that sponsored limited partnerships even though the individual partnerships nominally conducted the offerings

3. Critical issue is investors’ need for information concerning issuing entity

xvi. Rule 152 – Private Offerings Followed by Public Offerings1. Imagine: Private placement under a §4(2) exception, quickly following

by a public offering2. Rule 152 says that even if the factors suggest integration, the two x-

actions are not integrated3. But when does the first end and the second begin?

a. Best answer right now, is when the buyers are all unalterably committed to the first, it ends

xvii. Rule 155 – Abandonment of Offerings 1. Allows issuer to abandon private offering in favor of public offering or

vice-versa (without triggering integration problems) if abandoned before any securities are sold and conditioned upon a 30 day cooling off period b/w RS withdrawal and the private offering

xviii. Rule 147(b)(2): Integration Safe Harbor 1. – “for this rule … an issue shall … not include offers … pursuant to

the exemption provided by §3 or §4(2) of the Act or pursuant to an RS filed under the Act” outside of 6 months before/after other offers

XV. Secondary Offerings and Resalesa. Underwriter Concept

i. Sales of securities by non-issuers are within scope of §5 b/c it requires that every sale be either registered or exempt and §4(1) does not exempt transactions by “issuer, underwriter, or dealer”

ii. UW defined by §2(a)(11): 1. The term "underwriter" means any person who has purchased from an

issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security. . . ; but such term shall not include a person whose interest is limited to a commission . . . not in excess of the usual and customary distributors' or sellers' commission

iii. Functionally 4 roles qualify a person as an undertaker:1. any person who purchases from an issuer with a view to

distribution of a security (VIEW TO DISTRIBUTE)

2. any person who offers or sells for an issuer in connection with a distribution (AGENT)

3. any person who has direct or indirect participation in 1 or 24. any person who directly or indirectly participates in the underwriting

of such an undertakinga. Connection to the distribution is key. Just buying/selling is

not enoughb. Another Exemption: Average members of the selling group,

are not UWs if they don’t receive commissions beyond the normal dealer commission

iv. 4 Add’l Categories: 1. Any person who has purchased from a [control person] w/a view

to… the distro of a security [UW FOR CONTROL PERSON]2. Any person who “offers or sells for [a control person] in

connection w/the distro of any security3. Any person who “participates or has a direct or indirect participation

in any such undertaking”, ie. 1-24. Any person who “participates or has a participation in the direct or

indirect UW of any such undertaking”, ie. 1-2v. Results in 3 major categories:

1. Agent for issuer 2. Purchaser from issuer w/a view to distribute 3. UW for control person

b. Agent for Issueri. SEC v. Chinese Consolidated Benevolent Ass’n (2d Cir. 1941)

1. Facts: unregistered Chinese gvt bonds, CCBA of its own initiative facilitated sales in US

2. HELD: CCBA was a UW and violated SA §5(a) 3. TAKEAWAY: Huge reach of UW definition

a. Immaterial whether Chinese gvt (issuer) solicited or merely availed itself of the CCBA’s acts; still “for the benefit of” issuer in connection with distribution of bonds

b. Aim of the SA is to make info avail to investors and protect the public. These goals not served by focusing on issuer’s solicitation or contracting for UW svcs. Rather furnishing of adequate info is the key inquiry

c. Court also noted even if CCBA was not UW, it still was “participating in a transaction with an issuer” by funneling the money (steps necessary for distribution)

4. DISSENT: concern statute too broad; worried newspaper editorial urging purchase of bonds based on patriotism would make the paper an underwriter

ii. Expansive interpretations of “participates”1. SEC v. Allison (ND Cal. 1982): Anyone who has arranged for public

trading of an unregistered security or who has stimulated investor interest though advertising, research reports or other promotional

efforts can be considered to have “participated” in the issuer’s distribution

2. Harden v. Raffensperger (7th Cir. 1995): conducting due diligence on offering was enough to “participate in an underwriting” since it was a step necessary for the distribution

c. Purchase from an Issuer /a View to Distribute:i. Securities Act §2(a)(11):

ii. Meaning of “Purchase”:1. Not defined in the Act, but a sale requires the disposition of a security

“for value” (§2(a)(3))a. So, donee isn’t a UW unless gift is conditioned on donee’s

performance of an undertaking that would constitute the giving of “value” (e.g., a chair position to be named in the donor’s honor)

b. Pledge of stock as collateral for a loan is an “offer or sale” of a security within the meaning of §17(a) (Rubin v. US) problem for bank taking shares as collateral

iii. Meaning of “With a view to … the distribution” of the security:1. Seller must have purchased with investment intent or else resale

violates §52. Courts use an Objective test for investment intent – 2 factors:

a. Length of Time:i. <2 years: presumption against investment intent, but

may show by change of circs (below)ii. 2-3 years: investment intent is presumed (BUT

rebuttable)iii. >3 years: investment intent is established (irrebuttable)

b. Change of Circumstances: [NO LONGER VALID POST-144]i. Change in Purchaser’s (NOT issuer’s) circs may be

considered to show investment intent1. Policy: don’t consider change in issuer’s circs

since otherwise would permit a dealer to make speculative purchases in unregistered securities, and then unload the shares on the “unadvised public” without required disclosures. Gilligan, 2d Cir, 1959, CB 345

ii. The change must be something “basic and unforeseeable” (e.g., sale made to satisfy unexpected call by bank of demand note)

3. No violation unless there is a distributiona. For resales of registered securities by non-controllers, there’s

no resale Q b/c the RS applies b. For resales by non-controllers, there’s no distribution Q, if

there is investment intentc. If a non-controller can’t show investment intent, we enter the

distribution inquiry

i. Distribution: includes an offering of a security that’s req’d to be registered b/c the issuer’s offering d/n come to rest only w/ investors who satisfy the criteria of a single exemption from registration

ii. “a distribution exists if there are sales to those who cannot fend for themselves”

iii. The analysis is whether the resale destroys the exemption the issuer used in the first place, i.e., non-control persons can resell to persons who meet the criteria of of the exemption relied upon by the Issuer and hence her resale is NOT a distribution!

iv. ***Summary: Resale by a non-control person: first look to investment intent (i.e. holding period of some sort) then if not present look to whether it’s a distribution i.e. whether resale destroys the exemption under which issuer initially sold offering.

d. Control Person Distributions:i. Unlike normal purchasers, a control person is not protected by her

investment intent (i.e., even if the issuer’s offering has come to rest, investment intent does not protect resale of a control person’s shares):

1. Control persons may rely on 4(2) transaction exemption for IMMEDIATE resale to Ralston Purina (i.e. fend for themselves) qualified purchaser who would not destroy the issuer’s exemption.

2. Anyone who purchases from a control person, or sells for a control person, or otherwise participates, directly or indirectly, in a distribution of the control person’s securities is an underwriter (§2(a)(11)).

ii. Two Definitions of Control1. 1) Ability to direct management and policies of the issuer, Rule 405

a. Rule 405: “control” … means the possession, direct or indirect, of the power to direct or cause the direction of the mgt and policies of a person, whether through the ownership of voting securities, by contract, or otherwise ... common control with the issuer.

2. 2) Power to obtain signatures req’d to file an RSiii. US v. Wolfson, 2d Cir, 1968, CB 352 - Liability of Control Persons

1. W was company’s largest SH (40% interest). Sold >50% of his shares through various different brokers.

2. W’s liability -- 3 steps:a. W is a controller is a §2(a)(11) statutory issuer. b. If W is §2(a)(11) issuer, brokers are §2(a)(11) UWsc. If brokers are §2(a)(11) UWs, then the stock was sold in “x-

actions by UWs”d. X-Actions by UWs d/n enjoy the exemption of §4(1)e. W/out the §4(1) exemption, the transaction violated §5.

3. Broker’s Exemptiona. The brokers, however, are shielded by §4(4) broker exemption

b. But, W c/n rely on §4(4) broker’s exemption, since the broker’s exemption applies only to brokers.

4. Would W have violated the Act if he had sold his shares without a broker? Yes, since he would be acting as his own underwriter (i.e., someone “selling for a control person”)

5. Could W have sold his shares as part of a shelf registration or under Regulation D? No; since a control person is not a 2(4) issuer, they cannot take advantage of such issuer-based exemptions

iv. Why such a harsh rule for control person’s?1. Concerned that CP will take advantage of investors -- information

advantage2. Other ways for CPs to make public offerings3. Scott suggested CP rules may reach too far wrt public companies

(BUT there is Rule 144 alternative)e. The Broker’s Exemption

i. Securities Act §4(4): 1. Exempts from §5 “brokers’ transactions executed upon customers’

orders on any exchange or in the over-the-counter market BUT NOT the solicitation of such orders”

2. Distinguish “Brokers” from “Dealers”: a dealer buys/sells shares for/from his own inventory, whereas a broker acts solely as the agent in carrying out his customer’s purchase or sale.

ii. However, since all brokers are included in 2(a)(12)’s definition of dealer, brokers need never resort to 4(4) if for a specific transaction the broker’s conduct is already exempt under 4(3) or Rule 174.

iii. Example: a broker who sells to his customer registered securities of a reporting company is already exempt under Rule 174.

iv. Brokers who wish to rely on 4(4) must make a “searching inquiry” as to the character of the securities being offered for sale whenever a customer wishes to sell a substantial number of shares of a little-known company.

v. 4(4) exemption protects ONLY the broker; the broker’s client must seek his own exemption for a resale.

f. The “4(1½) Exemption” (is resale by a control person a distribution?)i. When control person can’t resell based on 144 (volume limit, issuer not

current in reporting, or sale not via broker)ii. § 4. Provisions of §5 shall not apply to:

1. transactions by any person other than an issuer, underwriter, or dealer2. transactions by an issuer not involving any public offering

iii. Is a §4(1) exemption in which there is no distribution, under the criteria for an issuer making a private offering under §4(2)

iv. Ie. a §4(1) exemption when offers and sales are to non-public investors:1. No distribution No UW No registration req’d. DONE.

v. The 4(1½) exemption is like a 4(2) exemption for transactions by individuals (who are not issuers and thus cannot technically rely on 4(2))

vi. Have to meet (somewhat relaxed) requirements of 4(2) for the resale to be exempt under 4(1)

1. Uncertain if sophistication is a requirement2. Although court in Ackerberg thought buyer sophistication was

important, casebook suggests that focus of 4 (1½) is – like focus of 4(1) – more on whether or not there is a “distribution”; by contrast, focus of 4(2) is more on whether the buyer can fend for himself.

3. Broad solicitations are inconsistent with 4 (1 ½)4. Number of purchasers must be small5. Information disclosure requirement6. Securities sold under 4 (1 ½) are considered restricted (i.e., purchaser

cannot resell without an exemption)g. Rule 144

i. Purpose of 1441. To let an affiliate get rid of its restricted shares

a. Affiliate defined in 144(a)(1)i. “control” defined by Rule 405

b. designed to let them resell into PUBLIC market2. To let an initial purchaser of a private placement to do the same3. Generally viewed as on of SEC’s most successful projects

a. SEC says that “distribution” is the key concept in defining “underwriter”

b. Act’s purpose and policy require focus oni. Disclosure

ii. Holding period to make sure people buying under 4(2) exemption assume economic risks

iii. Market impact of transaction1. 4(1) applies only to routine trades, not

distributionsii. Elements of 144

1. Applies to (144(b)):a. securities bought through non-public offerings or subject to

Reg D (restricted securities)b. Securities held by control persons (restricted and

unrestricted)2. Operative Provision:

a. any affiliate or other person as specified above shall be deemed not to be engaged in a distribution of such securities and therefore not to be an underwriter thereof within the meaning of section 2(11) of the Act if all of the conditions of this section are met 4(1) Exemption

3. Holding Periods (144(d),(k))a. NO HOLDING PERIOD FOR UNRESTRICTED

SECURITIES sold by control personb. NO HOLDING PERIOD FOR securities acquired under

504 (b/c they’re not restricted securities)(subject to certain restrictions)

c. d: one year for conditional sales (c,e,f,h) of restricted securities

d. k: two years for unconditional sales of restricted securities—but control persons always subject to conditions

e. N.B. No holding period for non-restricted securities4. Information Requirements and Volume Rules (c and e)

a. In the one year period for restricted securitiesb. Always for securities sold by control personsc. (c) requires current public information w/r/t issuer

5. Limitations on Manner of Sale (f)a. Must be through brokers during one year holding period for

restricted securities (brokers’ 4(4) exemption codified in (g))b. Always for securities sold by control persons

6. Notice to SEC Requirements (h)a. In the one year period for restricted securitiesb. Always for securities sold by control persons

7. Limitation on Amount of Sale: during previous three months amount of sale shall not exceed greater of:

i. 1% of class outstanding, orii. if traded on an exchange, avg. weekly volume on all

such exchanges within the preceding four weeksb. 144(e) sometimes requires aggregation of two or more sellers

in determining volumei. when securities are sold by pledgees, trustees, estates;

or when selling a convertible security and the security it’s convertible into

ii. DON’T count: (see 144(e)(3)(vii))1. securities sold pursuant to registration

statement, a Reg A exemption, a §4 transaction exemption and not involving any public offering, or offshore sales pursuant to Reg S

8. Rule not exclusive, but if you sell outside it you’re on notice that you have a heavy burden of proof and cannot ask for a no-action letter

9. Change in Circumstances NO LONGER RELEVANTiii. Important Definitions

1. “Restricted Security” – 144.a.3a. Securities acquired in non-public offering b. subject to Reg. D resale restrictions (even if Reg. D offering

is “illegal”)c. securities in Rule 144A transactiond. securities obtained in Reg. CE transactione. Reg S f. NOTE: §3.a.11 are NOT “Restricted” and thus not subject to

Rule 144 2. “Affiliate” – 144.a.1

a. “a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, such issuer”

3. Two different definitions of distribution: a. 1—Ralston Purina where a distribution occurs when the

investors are unsophisticated b. 2—Volume definition utilized in R. 144 where the key concern

is flooding the market.iv. Registered shares sold by control person REQUIRE re-registration:

1. Loss and Seligman: it’s an altogether different offering from the original distribution now that the control person is in control, so requires a new RS

2. Scott: informational advantage of CPsv. Selling Short to Circumvent Holding Periods

1. non-CP subject to 144 holding period for restricted stock, but unrestricted stock of same series trading on public market

2. then can sell public stock short to lock in profit and repay broker with the restricted stock at end of holding period

3. Policy:a. We don’t really care about holding periods when there is

already unrestricted public stock also tradingb. Full compliance with rules and separate policies

h. Rule 144A: Sales of restricted securities to QIBs by non-issuersi. Operational Provision 144A(b):

1. Sales by dealers or persons other than issuers, when compliant with 144A, are not distributions

2. therefore the parties are not UWs 3. therefore the exemption of §4(1) applies 4. therefore §5 is not violated.

ii. What does 144A do:1. For securities originally sold under Regulation D of 33 Act, you can

purchase from an issuer and then immediately resell without becoming an underwriter (under Rule 502(d) of Reg D) if you follow 144A

2. Doesn’t matter if you purchase intended to resell3. BUT:

a. DOESN’T extend to publicly traded securitiesb. DOESN’T “cleanse” shares of restrictions like 144

iii. Key Elements1. Eligible purchaser – Qualified Institutional buyers

a. Banks and S&Ls – i. Must invest in and own min. $100M in securities of

institutions other than the bank/S&L in questionii. Must have audited net worth of min. $25M

b. Registered Broker Dealers - Must invest in and own min. $10M in securities of institutions other than the dealer in question

c. Others - Must invest in and own $100M+ in securities of institutions other than entity in Q

d. Verifying Qualifications: Seller can rely on public info or info given by buyer to see he’s a QIB. Most of the info must be 16 months old, max.

2. Eligible Securities a. If similar securities are listed/registered, no exemption for the

new securities issued, 144A(d)(3)b. This also includes ADRs and convertibles if the underlying

security is traded publicly (unless conversion premium >10%)3. Defective Prior or Subsequent Sales Do Not Destroy 144A

Exemption, Rule 144A(e):a. Exemption under 144A will not be affected by prior or

subsequent x-actions by other sellers4. Holding Period: None5. Info : basic financial info when issuer doesn’t file under ‘34 Act or

furnish home country info under Rule 12(g)(3-2)(b)a. must be able to obtain—and be provided on request—

i. brief statement of business, and products and services offered

ii. most recent balance sheetiii. profit and loss and retained earnings statementsiv. similar statements for previous two fiscal years

b. Policy: does it make sense to have this requirement?i. Market seems to impose its own demand

ii. Typical 144A placem’t begins w/offer memo incl. extensive disclosures & warranties

iii. Broker-dealer’s counsel usually provides a “10b-5 opinion”

1. States that no fact is known to counsel suggesting any of the memo’s or disclosures’ statements are untrue

c. If all these disclosures are being made anyway, why is 144A so popular?

6. Seller must ensure buyer is aware seller may rely on 144A to avoid §5

7. Must be a Private sale 8. Liability:

a. Provides exemption only from §5 of the ’33 Acti. Therefore, no liability under §11, §12(a)(1), §12(a)(2)

b. Liability remaining:i. 10b-5

ii. Anti-fraud or other provisions of the Securities Laws (eg. ’34 Act registration)

iii. State laws9. Non-integration (144A(e)):

a. Offers and sales of securities pursuant to this rule shall be deemed not to affect the availability of any exemption or safe harbor relating to any previous or subsequent offer or sale of such securities by the issuer or any prior or subsequent holder thereof.

iv. What could be done to make 144A more attractive?1. Less restrictive QIB definitions2. No info requirements3. Reduce liability (10b-5, Parmalat)

a. Don’t violate Sec. 11 b/c not faulty underwriter and not 12(a)(1) and 12(a)(2)

b. But still liability under 10b5 c. If wanted to expand market, reduce liability in situations like

Parmalat4. Parmalat : PP to QIBs which trade in 144A market

a. Litigation against banks for facilitating the fraudv. A/B Exchange Offers

1. When restricted securities are exchanged for registered ones, exchanging security holders are named in registration statement as selling shareholders and thus have underwriter’s investigation burden

2. SEC No-Action Letters: exchanging shareholder avoids underwriter status if not otherwise a broker engaged in the distribution of a security (A/B exchanges)

3. SEC limits its position to nonconvertible debt, certain preferred stock, and foreign issuers’ initial U.S. offerings

4. Not available to U.S. issuers of common shares whereby restricted security is exchanged for a registered one

5. Occur increasingly around 144A, w/ institutional buyers obtaining agreement from issuer to exchange at a later date the registered for the unregistered securities

XVI. Ongoing Disclosure Obligationsa. Summary of Continuous Disclosure Obligations Under ’34 Act

i. Periodic Reporting Requirements (disclosure with respect to specified items)

1. Annual Statements, 10Ka. 60day delay, post December 2005, for “large accelerated filers”

(public float of $700 million or more, SEC Release No. 33-8617, September 22, 2005)

b. 75day delay for “accelerated filers,” companies with public float of $75 million to $700 million, 90 days for rest, Release 33-8617

2. Quarterly Statements, 10Q (SEC Release 33-8617): 40 day delay, post December 2005, for filers over $75 million of public float, 45 days for rest

3. Significant Events, 8K (4 business day delay, no 10b-5 liability for failure to file with respect to several events, Rule 13a-11(c), CS 920)

4. Item 303(a)(3) of Regulation S-K: 10Ks and 10Qs must include new material information (CS 327) (MD&A)

ii. Rule 12b-20 (’34) (counterpart of Rule 408 for registration statements, CS 138): must add further material informatin to prior required reports or registration statement (see those above) to make sure they are not misleading

iii. Common Law of 10b-5: cannot make material misrepresentations and must correct inaccurate prior disclosures (not in reports) that have become misleading: Basic, Wielgos, In re Time Warner

b. Duty to Update Between Required Reports (pros and cons)i. Pro:

1. Events happen, and valuable to get it out2. Makes for more efficient markets3. Price accuracy needed for allocation of resources4. Prevent volatility5. Better managerial discipline

ii. Con:1. Costs of disclosure; administrative costs and management2. Difficult to define materiality3. Disrupts business activity4. You get pricing accuracy every quarter; this increases volatility and

short-termism5. Can hurt existing shareholders, e.g. disclosure of merger negotiations

could kill the mergerc. 8K Required Disclosure

i. Old:1. Change in control2. Acquisition or disposition of significant amount of assets3. (expanded)4. Bankruptcy (expanded)5. Change in certifying accountant6. Resignation of a director, principal officer or election of director and

appointment of principal officer (expanded)7. Change in fiscal year8. Financial information in connection with an acquisition9. Results of Operations10. Optional: events of importance to shareholders11. Use to satisfy Regulation FD disclosure (prohibits selective disclosure)

ii. New:1. Enter into or terminate material agreements, not in ordinary course

(Items 1.01 and 1.02)

2. Creation of material financial obligation on or off-balance sheet (Enron) (Item 2.03)

3. Triggering events that accelerate or increase material financial obligations (Item 2.04)

4. Costs associated with exit or disposal activities (Item 2.05)5. Material impairment of assets (Item 2.06)6. Delisting or failure to satisfy a listing rule; transfer of listing (Item

3.01)7. Sales of unregistered securities (Item 3.02)8. Material modifications to rights of security holders (Item 3.03)9. Non-reliance on previously issued financial statements or a related

audit report or completed interim review (Item 4.02)10. Amendment to Articles or By-Laws (Item 5.03)

d. Requirements of Financial Reportingi. Statements prepared in accordance w/GAAP

ii. Reports are accurate and honestiii. Maintenance of reliable and trustworthy acctg recordsiv. Report must “fairly present” its financial position and operationsv. GAAP

1. Concern over manipulation2. 1st line of defense: Accounting metrics that are objective principles

and rules 3. 2nd line of defense: Outside/independent auditor (CPA).4. Non-accounting info is also important to investors and shareholders.

Disclosures mandated by SEC in Regulation S-K are a blend of accounting-based info and non-accounting info

e. Material Disclosures Required Under Common Law of 10b-5i. Speculative information and materiality:

1. Omitted fact is material if: (Basic v. Levinson)a. Substantial likelihood that reasonable shareholder would

consider it important in deciding how to voteb. Must be subst likelihood reasonable investor would consider

disclosure as altering the total mix of available informationc. Materiality defined based on probability/magnitude test

2. Facts: Basic (publicly traded) in talks to merge, but makes 3 public denials. Merger happens. SHs bring CA alleging injury b/c sold shares at artificially depressed prices in a market affected by misleading statements and in reliance thereon.

3. Court rejects 3rd C. Agreement in Principle Test4. No affirmative duty to disclose here, but must be truthful when

voluntarily disclosingii. Total Mix of Information: Efficiency and Truth on the Market

1. Truth on the Market: optimistic estimates not materially misleading because market surely understood the overstatements and discounted the consistently optimistic forecasts (Wielgos) (Easterbrook)

2. Facts: Facts: SHs sue issuer & UW. Claims violation of §11 b/c shelf RS contained defective estimates of cost & time for nuclear plants (incorporated by reference b/c S- filer)

3. Duty to disclose: (not discussed in case): but arguably not, b/c expense ESTIMATES made at time may not have been inaccurate, and expense estimates change, so no duty to correct

4. Policy: Is TOTM fair to rely on in discharging a duty to update?a. +/- of ECMHb. (-) Undermines the disclosure policy?c. (-) HS: Does the mkt know the size of the error?d. (-) HS: How can the mkt price in the error when it’s a shelf?

Maybe into bookbuilding?iii. Total Mix of Information: Puffery

1. Mere sales puffery not actionable under 10b-5 (Eisenstadt) (Posner)2. Facts: CA filed for those who bought Centel stock in reliance on

optimistic press announcements, where company said auction process was “going smoothly.”

3. Admissions Recommendation Logic: Puffing is so common that literal truth could be misleading, & c/b taken to mean prospects for auction were much grimmer than they actually were.

4. Policy: H. Scott: Seems to contradict Basic, where SCOTUS said “shut up, or tell the truth.” NOT “shut up, or lie and rely on TOTM.”

5. Virginia Bankshares v. Sandberg (US 1991), a. Objective falseness can be the basis for liability, when

statements of opinion relate to material facts, and therefore fall within the standard rules of antifraud provisions.

i. There was objective evidence presented to BOD that was inconsistent w/their professed opinions, so P pled more than mere subjective disbelief or undisclosed motive.

b. Moreover, here, the ct thought the info took material significance to the SHs, who rely on and look up to the BOD. OTOH, in Centel, puffery was the “order of the day” – everyone did it, and everyone knew everyone did it.

iv. Fraud in Connection w/Purchase or Sale of a Security: Affirmative Duty to Disclose

1. When a corp is pursuing a specific biz goal and announces that goal as well as an intended approach for reaching it, it may come under an obligation to disclose other approaches when those approaches are under active and serious consideration. In Re Time Warner.

2. Facts: Time announces search for “strategic partners” to infuse new capital. Lots of publicity, but search fails. Then propose 2 new rights offerings to existing SHs. Price falls in response.

a. Duty to disclose arises whenever secret information renders prior public statements materially misleading, not merely when that info completely negates the public statements.

b. Having publicly hyped strategic alliances, Time Warner may have come under a duty to disclose facts that would place the statements concerning alliances in a materially different light.

XVII. Forward Looking Statementsa. MD&A: Duty to Disclose Forward Looking Information

i. Provided for in Item 303 of Regulation S-K1. Purpose : Calls on management to provide narrative explanations of the

financial statements for the purpose of increasing the transparency of a company’s financial performance and of providing overall better disclosure to investors

2. What Must Be Disclosed: a. Trends and risks that have shaped the past and are reasonably

likely to have an impact on net sales … if registrant knows of events that will cause a material change in the relationship between costs and revenues … the change in the relationship shall be disclosed (Item 303(a)(3))

b. In the Matter of Caterpillar – SEC found that Cat should have disclosed the extent that its volatile Brazilian contingent contributed to its overall earnings

i. However : No 10b-5 private COA for Item 303 duty to disclose a pessimistic internal forecast (Verifone Securities Litigation)

3. What Need Not Be Disclosed : Merger negotiations if the company believes the disclosure could jeopardize the completion of the acquisition

4. Enron’s Contribution : a. Detailed presentation of “off balance sheet arrangements”

i. Data about off B/S entities that either have or are reasonably likely to have a current or future effect on financial condition, revenues, expenses, or liquidity that is material to investors. Item 303(a)(4)

b. Expanded list of things to be disclosed on 8-K:i. The making or terminating of a material agreement that

is not part of the ordinary course of businessii. The creation of, or default upon, a material financial

obligationiii. Credit rating changesiv. Asset impairment that leads to a material charge

b. Duty to Disclose Forward-Looking Information i. Soft information: events or activities that will occur, if at all, at some future

date. 1. Every reason to believe its materiality should be assessed by the

probability/magnitude standard applied in Basic. 2. Supreme Court expressed no opinion whether P/M test should be

applied across the board in assessing the materiality of all uncertain events

ii. Item 303: Directly requires management to assess the past performance of the biz and, importantly, to provide its view of what operations, trends, and forces will affect future operations. Must disclose trends that are likely to affect the firm’s financial performance, liquidity, or capital resources as well as the effects of inflation on operations.

iii. The duty to disclose soft information exists when the information is material and there is an independent duty requiring its disclosure (Murphy)

1. There is an independent duty to disclose soft information that arises from the overall rule that no half-truths should appear in filings with the SEC and public announcements Since the line-item disclosures mandated by S-K do not independently require disclosure of soft information and since many financial announcements are not the subject of SEC filings, the duty to disclose soft information generally arises from the overall obligation that announcements not be materially misleading

a. Note :i. Courts are extremely reluctant to deem a disclosed

statement misleading because it isn’t qualified or otherwise accompanied by an appraisal, a prediction, or an estimate that is materially inconsistent with the disclosed statement (Panter- 7th Cir. Held it was not a material omission for the management of a target company to report in a letter to stockholders higher 9 month earnings and not also to disclose an internal projection for year-end decline in earnings. The court reasoned that disclosure of projections would not be allowable unless they were “reasonably certain”)

ii. Don’t have to disclose if nondisclosure wouldn’t change the “total mix of information available” Kademian v. Ladish Co . - In which the 7th Circuit held that internal estimates of the intrinsic value of the issuer’s stock didn’t have to be disclosed in a proxy statement in which management sought stockholder approval of the firm’s merger at a price lower than the internal valuations)

iii. However : An intent to liquidate must be disclosed as must estimates about a hostile target company’s facts to the target company’s SHs (Feit v. Leasco Data Processing Equipment Corp.)

c. Liability for Forward Looking Statementsi. Common Law and Rule 175 Safe Harbor

1. Rule 175:a. (a) A [forward looking] statement … which is made by or on

behalf of an issuer …

b. shall be deemed not to be a fraudulent statement (as defined in paragraph (d) of this section), unless it is shown that such statement was made or reaffirmed

c. without a reasonable basis or d. was disclosed other than in good faith

i. This applies to a FLS made in a document filed with the SEC (b)(1)

ii. FLS = a statement containing a projection of revenues, income (loss), earnings (loss) per share, capital expenditures, dividends, capital structure or other financial items (c)

e. “Not to be a fraudulent statement” protects against all bases of liability in the ’33 Act, including §11 liability (Wielgos)

f. Under Rule 175, Forward looking stmts need not be correct, it is enough that they have a reasonable basis.

g. “Reasonable basis” : Cost estimates incorporated into that prospectus that have become stale and do not explain that these estimates are based on nothing going wrong in the market have a reasonable basis once they are understood as projecting forward from past experiences rather than trying to predict what new things can go wrong, provided that there are no other estimates (excluding tentative internal estimates). (Wielgos)

h. Firms need not reveal all projections. They make projections all the time and this would mean de facto continuous reporting. Rather they can choose which one they reveal so long as it has a reasonable basis. Moreover, they need not, under Rule 175, though they may, reveal underlying assumptions

i. Policy rationales:i. Want to encourage enterprises to disclose information:

enterprise will not be inclined to do so if there is a good chance they will be liable for them or if disclosure requires revealing all the data, assumptions and methodology behind its projections (competitors could use this to the detriment of the enterprise)

ii. Information that the cost estimates are inaccurate is already on the market and therefore will likely moderate/eliminate the potential of a dated projection to mislead

ii. Bespeaks Caution Doctrine 1. When an offering doc’s soft info is accompanied by meaningful

cautionary stmts, the forward looking stmts will not for the basis of a securities fraud claim if the stmts did not affect the “total mix” of info the doc provided to investors.

2. IOW: Cautionary language, if sufficient, renders the alleged omissions or misrepresentations immaterial as an MOL

a. Kaufman v. Trump’s Castle Funding - There was a misleading statement re: ability to pay back principal and interest on bonds, but the court found that it was overwhelmed by cautionary language and thus the statement was harmless.

3. OTOH: vague or boilerplate cautions that merely warn of the general risk of investment, will not be enough.

4. Rather: the warnings must be substantive and tailored to the specific forward looking stmts included in the document

5. A forward-looking statement is material if it rises to the level of a guarantee (Hillson Partners Ltd. Partnership v. Adage, Inc.) Vague, generally-worded statements of optimism can be deemed immaterial because they are mere puffery

iii. Statutory Safe Harbor For Forward Looking Statements1. PSLRA adds §27A to ’33 Act and §21E to ’34 Act which provide

statutory safe harbors for certain forward-looking statements (WRITTEN OR ORAL) made by companies that are subject to the Exchange Act’s continuous reporting requirements

a. Forward-looking statements includes financial projections, plans and objectives of mgt, statements of future economic performance, assumptions underlying the previous statements, reports issued by issuer’s outside reviewer assessing forward-looking statement, and projections or estimates of other items specified by Commission (§21E)

2. 1) First Safe harbor applies to:a. a) Immaterial forward looking stmts, andb. b) A fwd looking stmt that “is accompanied by meaningful

cautionary stmts identifying the impt factors that could cause actual results to differ materially from those in the fwd looking stmt

3. 2) Second Safe Harbor applies where:a. P fails to show that the fwd looking stmt was made w/ actual

knowledge it was misleading4. Possible Result: No liability for stmts the issuer knows are misleading,

but accompanies with cautionary language.5. Impt factors

a. 1) Relevant to the projectionb. 2) Could actually affect whether the fwd looking stmt is

realizedc. BUT the impt factors provided need not be all inclusive. This

is not carte blanche for P to seek discovery of other factors that m/h/b known, see §21E(f)

6. Safe harbor covers oral stmts, if they say where the cautionary info can be found

a. But see Easterbrook in Baxterb. Asher v. Baxter International, Inc. The market for Baxter’s

stock is efficient, therefore its cautionary language must be

treated as if attached to every one of its oral and written statement. Therefore, if suing on the fraud on the market theory, it doesn’t appear that the oral statement actually has to identify where the meaningful caution can be found. Then the only question left was whether statements satisfied statutory requirements.

i. The PSLRA doesn’t require the most helpful caution; it is enough to identify important factors that could cause actual results to differ materially from those in the forward-looking statement

7. Stay pending motion on Forward Looking Statements (21E(f))a. In any private action arising under this chapter, the court shall

stay discovery during the pendency of any motion by a D for summary judgment that is based on the grounds that:

i. the statement or omission is a forward-looking statement, and

ii. the exemption provided for thin this section precludes a claim for relief

8. Safe harbor not available for:a. Initial public offeringsb. Tender offersc. Going-private transactionsd. But these x-actions can still rely on SEC Rule 175 and the

“Bespeaks Caution” doctrine9. Assumption

a. Disclosure of assumptions underlying a forward-looking statement can prevent the statement from being misleading

b. However : assumptions generally don’t rise to the level of themselves being meaningful cautionary language

c. A leading pre-PSLRA case held that failure to disclose key assumptions was itself materially misleading (Beecher v. Able)

XVIII. Rule 10b-5a. Rule 10b-5:

i. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national exchange,

1. (a) to employ any device, scheme or artifice to defraud, [SCIENTER]2. (b) to make any untrue statement of a material fact or to omit to state a

material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

3. (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

ii. in connection with the purchase or sale of any security.b. Scienter Requirement:

i. Per Ernst & Ernst v. Hochfelder, private 10b-5 actions must show D acted w/scienter IOT succeed

ii. Alas, scienter is vaguely definediii. Dominant view is that it’s enough if the defendant knew true state of affairs

and appreciated the propensity of the misstatement or omission to mislead (even if no desire to mislead)

iv. Authority suggests that recklessness constitutes scienter for liability purposes under 10b-5

v. Martha Stewart: court dismisses criminal 10b-5 claim on ground that no jury could reasonably believe her purpose was to influence the price of MSLO instead was to express her innocence!

vi. Pleading Requirement: 21D(b) requires P plead with particularity facts giving rise to STRONG INFERENCE that D acted with required state of mind

1. Discovery stayed until pendancy of motion to dismiss (21D(b))c. Reliance

i. General Test: did the misrepresentation cause the plaintiff to buy or sell? (AUSA)

ii. No reliance required by SCOTUS in Fraud on the Market cases: In market transactions, “the market is interposed between seller and buyer and, ideally, transmits information to the investor in the processed form of a market price”, hence buyer relies on the integrity of the market (Basic)

iii. Presumption of reliance when there is a misprepresentation1. In Basic, the Supreme Court claims that empirical studies support the

ECMH, which suggests that any misinformation in the market will impact the price

2. Even if this is wrong (ie. people don’t rely on integrity of market prices), imposing a higher burden would effectively eliminate CA’s under 10b-5

iv. Presumption of reliance when there is omission (Ute)v. Extreme, problematic example: woman purchases stock relying on WSJ

article about new product line, company makes fraudulenet misrep/omission w/r/t something else, but she still gets recovery (Panzirer)

1. possible explanations: WSJ article might have had diff tone; broker would have warned her

d. Loss Causationi. PSLRA 21D(b)(4): In any private action . . .the plaintiff shall have the burden

of proving that the act or omission of the defendant alleged to violate [this section] . . . caused the loss for which the plaintiff seeks to recover damages.

ii. Dura (2005, SCOTUS): P must demonstrate price drop caused by D’s alleged misreps or omissions

1. Facts: Two different misreps: earnings lower than expected and then no FDA spray approved, both resulted in price drops, but then 12 trading days later, recovers a little

2. No liability for inflated purchase price b/c of misrep – P could always have sold at that price!

iii. Other Tests (AUSA, 2nd C)

1. Oakes: base loss causation on foreseeability: a. Why focus on scienter rather than causation?

2. Jacobs: was it foreseeable that EY would know that inaccurate financials could lead to an acquisition of a bad business?

3. Winters: looks mistakenly at reliance: question is whether investors would have invested in the notes if they had known they were dealing with management that had misstated financial information

e. Damagesi. P only gets damages for amount of loss the D actually caused

(CAUSATION ELEMENT)ii. Rowe v. Maremont (7th C., 1989): family sells stock to buyer, who promises

not to do tender offer but later does, loses, but then sells family’s stock for $4M profit; court only awards family $745k b/c that’s the amount he believed they would have bargained up for had they known he was going to do a tender offer (essentially he knew they were going to sell regardless and soon)

1. “Being a rescissionary measure of damages, disgorgement is meant to place a defrauded seller in the same position as he would have occupied had the buyer’s fraud not incuded him to enter the transaction.”

XIX. Regulation FDa. Summary of Regulation FD: NO SELECTIVE DISCLOSURE

i. When an issuer, or person acting on its behalf (senior official), discloses material nonpublic information to certain enumerated persons, e.g. securities market professionals and security holders who may trade on the basis of that information, it must make public disclosure of that information.

ii. For intentional disclosure, public disclosure must be simultaneous, for non-intentional disclosure it must be made “promptly” (the later of 24 hours or the commencement of the next day’s trading on the NYSE).

b. SEC reasons for Reg FDi. Selective disclosure to analysts is similar to insider tipping

1. “Privileged few” benefit from nonpublic information2. adversely affects the market

ii. Corporate managers use inside info to “bribe” analysts1. analysts feel pressured to report favorably

iii. Technology makes it easier to make the information public quickly1. internet webcasting2. teleconferencing

c. Narrowed scope of Reg FD (safeguards against potential “chilling effect”)i. FD only applies to the following people

1. securities market professionals2. security holders who are likely to trade on the basis of the information

ii. FD only applies to disclosures from 1. senior corporate officials2. those people who regularly communicate with securities market

professionals (analysts) or securities holdersiii. FD gives NO private or SEC cause of action under §10b-5

iv. Only applies when issuer’s personnel “know or is reckless in not knowing” that info is material and non-public

v. does not affect eligibility for short-form registration or resale under Rule 144d. Other limitations to Reg FD

i. Does not apply to most registered securities offerings (road shows, etc…)ii. Does not apply to foreign governments or foreign private issuers

e. Tippee Liability Pre-FD (Dirks)i. SEC Position: “Where ‘tippees’—regardless of their motivation or

occupation—come into possession of material information that they know is confidential and know or should know came from a corporate insider, they must either publicly disclose that information or refrain from trading.”

ii. SCOTUS in Dirks: 1. no duty to disclose if there’s not fiduciary nexus between tippee and

corporation2. duty to abstain from trading only when

a. tippee knew the tip was a breach of insider’s dutyb. insider tips in order to gain personal benefit

i. pecuniary gainii. reputational benefit

iii. curry favor with analysts3. Facts: during investigation receives information from insiders

confirming fraud, discloses to third partiesiii. FD doesn’t focus on tippee, but instead requires full disclosure by insiders to

prevent this situation from happeningf. Impact of Reg FD on Flow of Information to the Market (Analyst Calls)

i. Summary of Studies:1. Fewer analyst calls (but not sure of impact)2. Conflicting conclusions about impact on continuous flow of quality

info (Gomes v. Bushee/Heflin)3. Appears there is no more insider trading (although difficult to say)4. SO if anything, Reg FD might have worked, but data is not clear

ii. Bushee Study: minimal evidence of sign. Negative impact of FD1. Companies that had formally closed calls had fewer calls post FD2. Companies that had open calls before continued with changing timing3. Ultimately, less information coming out in conference calls4. But same amount of absolute information: so many diff channels,

press releases, etc…doesn’t have to just be thru conf calls: can always use press releases, which reach wider audiences (query how efffective they are in comparison though)

iii. Heflin: Regulation FD and the Financial Information Environment1. Methodology—examine trading volatility, price changes, and number

of voluntary disclosures post and pre Reg FDa. Trading Volatility: lower volatility overall after earnings

announcements (suggests more efficient dissemination of previously selectively disclosed info)

b. Price Changes: price converges more quickly to post earnings announcement level (suggest more efficient dissemination of info)

c. Voluntary Disclosures: overall more voluntary forward looking disclosures

d. Other aspects of analysis (accuracy, bias, dispersion): no reliable data suggesting change

iv. Gomes: SEC Regulation Fair Disclosure, Information, and the Cost of Capital1. Methodology—examines cross section of firms of different sizes pre

and post Reg FD2. Conclusion:

a. small firms may be affected more by Reg FD since big firms are likely to already have efficient information dissemination systems in place

b. small firms unable to adopt other means of disclosure as easily as big firms

3. Problem: study took place near analyst settlement, so could be other major reason for drop in analyst coverage

v. Recent study (23 contemp acc research 491 2006): post-FD, analysts covering SMALLER firms rather than BIGGER firms

1. finds fall off of analyst coverage (attempting to control for settlement) 2. however, the falloff is in the big firms and not the small firms3. the hypothesis: analysts think they’ll get a bigger payoff on doing

research on smaller firms vi. Has FD led to more insider trading?

1. What would be the story? It increases the payoff to insider trading…no longer the opporutnity for quid pro quo with analyst, so instead might just trade on the informationb /c presumably people

2. If we obvsered LESS or the SAME volatility near the announcement, that would be evidence of insider trading

XX. Aiding and Abetting Liabilitya. No private 10b-5 aiding and abetting liability – must find the party itself was a

primary participant in the fraud. Central Bank.b. 20(e) confirms that SEC may bring aiding and abetting liability claim under 10b-5c. Elements of Aiding Abetting Liability pre Central Bank of Denver

i. Existence of an independent disclosure violationii. Actual knowledge (maybe recklessness) by the aidor/abettor of the

misrepresentation and of his role in furthering itiii. Aidor/abettor provided substantial assistance in the transaction giving rise to

the investor injuryd. Cenral Bank of Denver v. First Interstate Bank of Denver 511 US 164 (1994)

i. Facts1. D was the indenture trustee of bonds, failed to ensure that land value

for mortgage was at least 160% of bond value.2. No deception or misrepresntation3. Bond issuer defaults

ii. Arguments1. SEC—“directly or indirectly” language in §10b-5 invites secondary

aiding/abetting liabilitya. Court says NO, would proscribe legal conductb. Would also create unintended secondary liability for other

sections of the Exchange Actiii. Holding

1. To allow aiding/abetting liability for secondary offenders would circumvent RELIANCE requirement of 10b-5: investors must have relied on defendant’s misstatements or omissions for private liability to attach

2. Essentially, if secondary actors (lawyers, accountants) are to be liable, they must be liable as primary actors

iv. Dissent1. this is a new interpretation of a statute that allowed secondary

aiding/abetting liability for 30 years.2. undermines forms of liability long recognized by SEC

e. Wright v. Ernst & Young LLP (2nd Circuit, 1999)i. “Bright line” test: NO liability for misrepresentations not attributed to the

defendant at the time of the of the stmt’s dissemination (the time of the investment decision)

ii. Facts1. E/Y “ensured” the accuracy of BT’s accounting results2. BT then disseminates those results to investors

iii. Holding1. must meet Denver test of material misstatement upon which plaintiff

relied.2. No reliance here, since EY isn’t mentioned at all in BT’s report3. NO liability for misrepresentations not attributed to the defendant

at the time of the of the stmt’s dissemination (the time of the investment decision)

4. NO substantial participation in the fraud by EnY because EnY weren’t “controlling persons” as in First Jersey

a. First Jersey: director told employees to make false and misleading statements

5. DECLINE to adopt the “substantial participation” of other jurisdictions

f. Tests for aiding/abetting liabilityi. Substantial participation test (adopted by 9 th circuit)

1. attempts to define those who would previously have been aidor/abettors as “primary participants”

2. must participate substantially in the drafting and editing of documents with the knowledge that they will be disseminated to investors

ii. Bright line test (proposed by SEC) 1. primary participant: a person acting alone or with others [who] creates

or makes a misrepresentation [on which the investor-plaintiffs relied]

2. Person who doesn’t make the misstatement not a primary participantg. SEC Proposed Statement on Complex Structure Finance

i. Requires due diligence by financial institutions for elevated risk CSFTsii. Why?

1. SEC Concerned with investor protection – wants financial institutions to be gatekeepers

2. Fed and other banking agencies want to protect their regulatees from risk

iii. Elevated Risk CSFTs:1. Transaction lacks substance or business purpose2. Designed principally for questionable accounting, regulatory or tax

objectives3. Raises concern that client will disclose in misleading way4. Involves circular transfers of risk that lacks substance5. Involves side oral or undocumented understandings that if known

would have material impact on accounting, regulatory or tax treatment6. Economic terms inconsistent with market norms7. Provides compensation to the financial institution disproportionate to

the services renderediv. Due Diligence Required

1. High level approval with input from staff independent from business unit

2. Documentation3. Tone at the top: ethics policy4. Monitor compliance with procedures5. Training6. Regular audit

v. Accounting and Disclosure (2004 Version): [part of making the FI the GATEKEEPER]

1. Most controversial part which was dropped2. Financial institution had to understand how the customer would

account for the transaction!3. FI should have policies as to when third party should be engaged to

determine appropriate accounting4. Where proposed transaction may result in materially misleading

statement, FI may decline to participate or condition participation on customer making accurate disclosurs

5. FI should consider getting reps and warranites from customer state purpose of transaction and that customer will use correct accounting

vi. What were the FI’s concerns about this?1. Raises the cost of doing these transactions 2. How do you find out how they ACTUALLY do the accounting? 3. Why put culpability on banks?

a. Gatekeeper liabilityb. Makes it easier for SEC to enforce

XXI. Enforcement: Federal and State

a. Federal Enforcementi. SEC has discretionary power to investigate past/current/future violations.

1. Exchange Act, sec. 21(a).2. Rules of investigation—SEC Rules, 17 CFR §§201.1 et seq.3. Policy:

a. Structural bias toward bringing enforcement action once investigation is underway?

b. Fairness?c. SEC can’t use enforcement powers to establish regulatory

policy: line of cases dismissing SEC actions b/c defendant lacked adequate notice that SEC considered their activities violations. Upton v. SEC, 2nd Cir. 1996, p. 773.

ii. Informal/preliminary investigation—non-public, relies on voluntary cooperation.

iii. Formal investigation—1. SEC staff need reason to believe violation occurred + formal order

from Commissioners.2. Basically unrestricted power of SEC to investigate (if in good faith). 3. Subpoena power—enforced through federal district court. 4. Notice to target of investigation not required when 3rd party

subpoenaed. 5. SEC powers not restricted by contemporaneous criminal investigation,

absent showing of actual prejudice. SEC v. Dresser Industries., US 1980, p. 772.

iv. Recommendations to Commission: (non-public meeting, no right to notice, or right to appear)

1. Wells submission: SEC may grant target an opportunity to submit a written statement. Tricky for lawyer b/c nature of charges unknown and evidentiary privileged probably waived.

2. Settlements: most recommendations include offers to settle (SEC limited resources).

a. Most SEC enforcement actions are settled not litigatedinjunction or other relief w/ no admission of guilt.

b. Settlements as Rulemaking: the settlements create a body of securities law principles that have not been tested through formal rulemaking or litigation.

3. Cautionary letter to target (non-public--SEC may forward to NYSE, NASD, other SRO).

4. Section 21(a) Report: (published/public)a. Controversial use by SEC as determination of guilt w/o a

benefit of a hearing.i. SEC can require “any person” to submit written

statement—often admission guilt.ii. Analogous to consent decree--SEC uses to push reform

or change target’s practices.

b. SEC also uses 21(a) reports to comment on practices it sees as inappropriate but not actual violations.

v. Administrative Proceedings:1. Types of Administrative Proceedings (see list of typical proceedings,

p. 778-79).a. Refusal and stop order proceedings—for defective registration

statements.b. Section 15(c)(4)—for defective periodic reports, TO, proxy

(misleading or tardy).2. SEC Rules of Practiceprocedural requirements. Initial Pleading,

answer to be filed w/in 20 days, independent admin. law judge presides over hearing, limited discovery, ex parte depositions allowed, Federal Rules of Evidence do not apply.

a. SEC must prove violation by “preponderance of the evidence.” Steadman v. SEC, US 1981.

b. Resulting sanction must be in the public interest.vi. Cease and Desist order—(powerful augmentation of SEC enforcement

powers).1. Quick, flexible, can tailor to offense, efficient for minor or isolated

offenses.2. Permanent cease and desist—bans future violations and may include

disgorgement or affirmative steps to prevent future violations.3. Temporary order—target must refrain from violation pending a

hearing.4. Violation of cease and desist ordercourt imposed civil penalty

and/or mandatory injunction directing compliance w/ order.vii. Civil Penalties and Disgorgement:

1. Authorized by Section 20(d), 33 Act and Section 21(d)(3), 34 act.2. Civil Penalty -- $5K/violation for most minor up to $500K/violation

for fraudulent/deceitful.3. Disgorgement – alternatively court can substitute “gross amount

defendant gained through violation”4. Fair Fund provision of SOX §308, and disgorgement may be added to

fund for investors.5. Earnings Restatements, SOX §304: if earnings restatement is result of

earlier “misconduct,” CEO/CFO must disgorge to issuer any bonus or other incentive during the year following the original release of the restated financials.

viii. Officer and Directors bars:1. Authorized by Section 20(e), 33 Act and Section 21(d)(2), 34 act.2. Courts in SEC enforcement may suspend or bar for fraud or unfitness

to serve.3. Standard: must find violation likely to recur. SEC v. Patel, 2nd Cir.

1994, p. 788.ix. Trading Suspensions:

1. SEC can suspend trading for up to 10 days to protect the public interest. Sec. 12(k), 34 Act.

2. May tack multiple 10 day suspensions only if give notice and opportunity for a hearing. SEC v. Sloan, US 1978 (SEC issued continuous series of 10 day suspensions over 13-months).

3. May also indirectly prevent trading in a security by revoking registration under the 34 Act. Section 12(j). (also requires notice/hearing and finding necessary to protect investors).

x. Freeze Assets:1. Caselaw: Must show 1) likelihood of success on merits, and 2)

legitimate concern the D will dissipate/move the assets. SEC v. Unifund SAL, 2nd cir. 1990, p. 798.

2. SOX §21C(c)(3)—authorizes initial 45-day freeze where “lawful investigation” into a possible securities violation, w/ addition 45-days available for good cause.

xi. Injunctions: 1. Must apply to federal court for this Section 20(b), 33 Act and Section

21(d), 34 act.2. Need: bare showing that a violation has been committed + show

realistic likelihood of recurrence. SEC v. Commonwealth Chemical Securities, 2nd cir., p. 793.

3. Ancillary relief: disgorgement, rescission, appointment of a receiver, appointment of special counsel to investigate violations, appointment of independent directors to target’s board.

a. Determining amt. of disgorgement: need only be a reasonable approximation of profits casually connected to the violation. First City, DC Cir., 989.

4. Collateral consequences: Bad Boy statusa. Disclosure of injunction in reg. statement under 33 Act and

periodic reports under 34 Act.b. Professionals who “practice” before SEC may be suspended for

up to 1 year. Rule 102(e). Broker dealers can be suspended up to 1 year, Sec. 15(b)(4), and barred from advising/employee of investment company, Section 9 of Investment Company Act.

c. Unworthy Offering doctrine: barred from using Regulation A or Rule 505.

5. Collateral Estoppel: a. Court issued injunction from SEC actionfinding of guilt.

May be used by private litigants in subsequent private action to support summary judgment. Parklane Hosiery, US 1979.

b. Administrative adjudications by the SEC may also be used by private litigants for collateral estoppel if there was opportunity to fully and fairly litigate the issue.

6. Lifting the Injunction: very difficult—circuit split on exact standard.a. Need “showing of grievous wrong evoked by new and

unforeseen conditions,” (Cardozo), US v.Swift, US 1932. (9th

cir. still requires this—must have unforeseen and significant change in circumstances.)

b. 2nd Cir: “decree not properly adapted to accomplishing its purposes.” (p. 797).

c. 3rd Cir: Not dissolving will work “an extreme and unnecessary hardship on Ds.”

xii. Criminal Enforcement:1. Policy: is this proper use of the criminal justice system?

a. Powerful deterrentb. Criminal and civil cases can proceed simultaneously.c. Highly technical statutes—regulatory crimes.d. Victimless crimes: “investor/public confidence,” or “corporate

suffrange.”2. Criminal provisions of the securities laws – Section 24, 33 Act and

Section 32, 34 Act.a. Crime to willfully violate statutory provisions, or promulgated

rule/regulation.b. Crime to “willfully” make a false statement in document

submitted to SEC, 33 Act.i. 34 Act requires “willfully and knowingly.”

ii. Willfulevil purpose (in criminal context).iii. Knowinglyconsciousness of guilt

c. Maximum penalties established.i. No imprisonment if unaware your act/omission was

illegal. Sec. 32, 34 Act.3. Mail and Wire fraud, 18 USC §§1341, 1343.

a. Elements: 1) scheme to defraud, and 2) mailing a letter for purpose of executing the fraud. Pereira v. US, US 1954, p. 839.

i. Must prove knowledge of a scheme to defraud and purpose to defraud.

ii. Negligence or innocent misstatement NOT enough. iii. Circuit split on recklessness (11th, 3rd, 9th yes; 5th and 2nd

no), p. 839. b. Penalties: fines + 20 years (30 if victim is a financial inst.).c. Uses: full range of fraudulent investment schemes, stock

manipulation, lie/omission in sale of securities.4. Racketeer Influence and Corrupt Organizations Act (RICO), 18 USC

§§1961-1968.a. RICO defines securities fraud as racketeering.

i. §1962(a) bans using/investing $ from racketeering to acquire an interest in an enterprise engaged in commerce.

ii. §1962(b) bans using a pattern of racketeering activity to acquire an interest in an enterprise engaged in commerce.

iii. §1962(c) bans using a pattern of racketeering activity to conduct the affairs of an enterprise engaged in commerce.

iv. §1962(d) bans conspiring to do any of the above.b. Most SEC claims based on 1962(c). §1961(5) defines “pattern

of racketeering activity” only vaguely. Must commit two or more “acts of racketeering” w/in 10 years.

i. Securities fraud, as well as mail and wire fraud, defined as racketeering.

ii. PLSRA amended §1964(c) to no longer include fraud in purchase/sale of securities under definition of “pattern of racketeering activity”

c. Criminal Penalties: fines, imprisonment, mandatory forfeiture of property acquired in violation of RICO. Asset freezing power while awaiting trial, upheld in US v. Monsanto, US 1989.

d. Civil Penalties: divestiture orders, injunctions, dissolution of the enterprise.

e. Private litigants: private parties may recover treble damages + costs and attys fees.

xiii. Obstruction of Justice, 18 USC 1513(b)(2)(A) and (B): Arthur Andersen v. US, US 2005.

1. Witness tampering, destruction of documents, evidence tamperingfines + 10 years.

2. “for use in an official proceeding:” need nexus b/t the obstruction and an official proceeding.

3. “knowingly … corrupt:” requires mens rea—wrongful, immoral, depraved, evil. Merely impeding govt’s factfinding ability not enough.

b. Private Enforcementi. PSLRA, 1995. (Section 27 of Securities Act, Section 21D of Exchange Act.)

1. Centerpiece is appointment of “lead plaintiff.” §27(a)(3) and §21D(a)(3)—rebuttable presumption that plaintiff w/ highest stake is “most adequate plaintiff.” Intent is to harness the incentives/sophistication of the institutional investor.

2. No discovery until after the defendant’s motion to dismiss.3. Raised pleading standard to require pleading with particularity as to

raise a “strong inference” that D committed violation.ii. Razorfish, SDNY 2001, p. 719.

1. PSLRA says presumptive lead plaintiff is one with biggest stake in litigation, who then selects counsel. Court says “single sophisticated entity” most effective. Large stake provides incentive for close supervision of counsel, and strong negotiation of attys fees.

2. Court can reject highest-stake plaintiff w/ attys fee proposal court finds unreasonable.

3. Court rejects Auction system (sealed bids for attys fees arrangements submitted by competing law firms and lowest qualified bidder is designated lead counsel).

iii. “Fairness” of class action settlements: 1. PSLRA added Sec. Act §21(a)(6), Exch. Act §21D(a)(6)—attys fees

and expenses cant exceed reasonable percentage of any damages/interest paid to the class.

a. Subsection (a)(7) of each of the above also require extensive disclosure and notice.

2. Paying lead plaintiffs: why is this bad?c. State Blue Sky Laws

i. Registration: Uniform Securities Act 3 procedures for registering securities w/ State.

1. Notification: available for seasoned, quality issuers (age 5+ years, no default past 3 years on interest or dividend payments, 5% return on capital past 3 years).

a. Must notify state of offering, give some basic info, copy of prospectus.

2. Coordination: available if registration statement filed w/ SEC under 33 Act.

a. Must file copy of reg. statement and any amendments w/ state administrator.

b. Effective automatically when SEC reg statement is effective.c. Offers to sell okay b/t filing and effective date, but actual sales

only after effective.3. Qualification: applies to offerings that are exempt from registration

under the 33 Act.a. Must file a registration statement in each state where an

offering will be made.b. Extensive disclosure required under Uniform Securities Act

(states vary widely—so it’s a big pain for the attys if many states are involved).

c. Merit review: 40 states authorize administrator to review substantive merits of the offering. See SEC Report 8-9, p. 242. NASAA—model merit standards, p. 243.

d. Effective only when state administrator says it is.ii. Financial institutions exempt: National Bank Act completely preempts state

law for banks.1. Appropriate model for securities regulation? Why the overlapping

regimes?iii. “Covered Securities” exempt:

1. Section 18, 33 Act states intention to preempt state law for “covered securities.”

2. Covered Securitiesa. if listed or will be listed on NYSE, Nasdaq or American Stock

Exchange. §18.

b. Also if listed on Pacific Exchange, Philadelphia Exchange, and Chicago Board of Options Exchange.

c. Private offerings exempt under Section 4(2).d. Offerings to Qualified Purchasers, exempt under ???.

iv. Securities Litigation Uniform Standards Act (SLUSA), §28(f), 34 Act. 1. After PSLRA passed in 1995, many class actions diverted to state

court. SLUSA designed to stop this flow.2. Gives federal courts exclusive jurisdiction over most securities

class actions. §28(f), 34 Act. No state jurisdiction for “covered securities.” §18(b). see above.

3. Delaware carve-out: DE can hear fiduciary claims under DE state law.

v. State enforcement:1. “effectiveness of the capital markets” will not be foremost in minds of

state officials-should the federal government be exclusive?2. Federal regulation preferable b/c SEC/Federal Reserve properly

insulated from political processes. 3. State atty generals are not—elected officials may be partisan/self-

interested in enforcing the law.4. Working group created to address conflict b/t state/federal regs--12

SEC/NASAA officials.d. Notes on Enforcement Reform (imposing fines on issuers): SEC decision to

impose a civil penalty on an issuer turns on two primary factors:i. Presence or absence of a direct benefit to the corporation as a result of the

violationii. The degree to which the penalty will recompense or further harm the injured

shareholdersiii. Other factors:

1. Need to deter certain types of offenses2. Extend of injury to innocent parties3. Whether complicity in the violation is widespread throughout the

corporation4. Level of intent on part of perpetrators5. Degree of difficulty in detecting particular type of offense6. Presence or lack of remedial steps taken by the corporation7. Extent of cooperation with SEC and other law enforcement

e. Coffee Article on Securities Reform: i. Deterrence has to be the only rationale that can justify securities class actions

ii. Punishing corporation and shareholders is much like punishing victims of burglarly for having suffered a burglary; might lead to additional precautions, but not the most efficinet or fair way to solve the problem

iii. 21D(f) of PSLRA requires factfinder in securities class action to apportion liability among the covered persons (all defendants); no Joint and Several Liability JSL unless knowing violation…how to apportion liability to issuer tho?

iv. Suggests that in settlements, independent directors must evaluate fairness of settlement proposal to corporation and explain it publicly to shareholders

v. Require this as mandatory 8-K filing.vi. Issues:

1. Creates a liability potential for the directors issuing the statementa. Answer: that’s a good thing, will force them to be more

diligent in approving settlements2. Adds to litigation risk of being an outside director fewer outside

directorsa. Outside directors have virutally no anti-fraud liability,

negligence only actionable under Section 11, and they could easily be indemnified

vii. Perhaps require different insurers to cover directors as distinct from the issuerviii. Change plaintiffs attorneys fee structure to give incentive to get more

recovery from directors than corporation through differential contingency feesf. Spitzer: better to let federal gov’t regulate rather than politically motivated state AGs.

i. Martin Act in NYS has no reliance requirement like the analagous federal securities laws

XXII. Committee on Capital Markets Regulationa. Competitiveness: Is there a problem? Is it important?b. Regulatory Process

i. SEC cost-benefitii. Principles-based regulation

iii. SEC and DOJ have last word on matters of national importance (legislation)c. Enforcement

i. Resolving 10b-5 uncertaintyii. Eliminate duplicate recovery under SEC Fair Funds and private actions

iii. Prohibit pay-to-play for the securities bar (legislation)iv. Criminal prosecutions of companies as last resort (where rotten from top to

bottom)v. Congress to consider caps/safe harbors for auditing firms (minimum capital

and federal investigation when triggered, with possibility of corporate monitors) (legislation)

vi. Outside directors protected against Section 11 liability (due diligence under Rule 176) for good faith reliance on audited and unaudited financial statements (see WorldCom)

vii. SEC permits corporate indemnification of outside directors for acting in good faith

d. Shareholder Rightsi. shareholder votes on poison pills of companies with staggered boards

(legislation or listing requirements)ii. endorse majority voting

iii. shareholders free to choose remedies, e.g. arbitration without class actionse. SOX 404

i. new materiality standard for 404 and financial statements—reasonable possibility that poor controls or accounting treatment could have a 5% or more

impact on pre-tax income (currently “greater than remote possibility effectively means 0.0005% probability, according to Grundfest)

ii. Small companies: defer application until major changes, if still too burdensome Congress to consider exemption from auditor attestation and lower level of management certification (possible legislation)