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SECURITIES REGULATION Issuer Transactionsinvolving the sales of securities by the issuer to investors Trading transactionspurchasing and selling of outstanding securities among investors Primary Market=new companies, new IPOs Only a select few can get a piece of it at first Secondary Market=old stocks There is much more information involved and EVERYONE can buy or sell these HYPO: If you want to raise $100 million Bond Issueborrowing at an interest rate People need a level of security before they invest with you and take on your debt Security Interestan asset-backed dealthese assets set aside for debt, make the interest rate lower Restrictive Covenantsagree to NOT take on any more debt Equity Cushionputting X amount of capital aside for debt Must think creatively of what will increase investor interest and lower interest rate DEFINITION OF SECURITY SEC v. WJ Howey (1946) Issuer as a citrus grove, selling it to people as an investment little plots, issuer does ALL of the work ISSUE: Is this an INVESTMENT CONTRACT which would make it a SECURITY under 2(1) of the 33 Act making it have to be REGISTERED under 5? YESthis IS AN INVESTMENT CONTRACT, HOW: (1) Must be an investment of money (2) Into a common enterprise (3) For profit (4) Profit derived SOLELY FROM THE EFFORTS OF OTHERS Investor must have significant and essential managerial efforts There was an investment of money, into this common enterprise, for profit, and Howey did everything that derived the profits United Housing Foundation v. Forman (1975) Housing development, told people that if they bought 18 shares of stock then they could get a room for the low price. They did, but price went up, bring suit saying this is a security ISSUE: Is this a security NOThis is NOT A SECURITY Stock: NOT A STOCK HERESubstance over Form Could NOT assign it, pledge it, use it for loan, no rights to profit ONLY could CONSUME IT If you leave have to sell it back at FIXED price, NOT at profit How to figure out if it is stock: Called stock; issued by company; given for profit; gives a share of profit; maybe derived from the efforts of others; cannot have major control by the investor. The right to receive dividends contingent upon profits Negotiability Ability to be pledged as collateral Voting rights Capacity to appreciate in value Sale of it by a corporation RULE: when a purchaser is motivated to use or CONSUME the item purchases then the securities laws do NOT apply SEC v. Edwards (2004)the FIXED return People invested in a payphone sale and leaseback deal for investment, Edwards does ALL OF THE WORKLike Howey People got a 14% annual returnA FIXED RETURN Company goes belly up ISSUE: Is this an investment contract, thus a security, even when it is a FIXED return rather than a VARIABLE return YES THIS IS AN INVESTMENT CONTRACT Security definition is BROAD in order to be FLEXIBLE to adapt to all of the situations in which people devise plans to scheme others SATISFIES ALL OF THE ELEMENTS OF HOWEYBUT, FIXED RULE: Does not want circumvention, NO distinction between FIXED return and VARIABLE return Belmont Reid Buying gold coins off of a company that is going to refine them soon so that they can catch the rising market for gold and be WORTH MORE Investment ContractHOWEY Money: YES Expectation of Profit: Yes Common enterprise relying solely on others for profit Relying on them to refine in order to catch rising market YES, investment contract because of this reliance If NO rising market, NOT an investment contract, just relying on market Chinchilla Case You buy a chinchilla, take care of it, then it has babies and the promoter buys them back from you at profit Investment contract? Howey: Money: Yes Profit: Yes Common enterprise relying on the efforts of others: The investors took care of the animals HOWEVER, their resale came from the promoters making their success rely on the efforts of others Also, they are not expert investors AND there is a lack of disclosure here: They are very challenging to raise and die a lot of the time The court does NOT want to allow circumvention of the regulations by giving investors NOMINAL participation AND the court wants to PROTECT investors from shady schemes. NOMINAL PARTICIPATION NOT ENOUGH McSushi Case Franchisee manager NOT an investment contract NOT relying on efforts of othersYOU MAKE THE DAY TO DAY DECISIONS Vertical Commonality Whether the activities of the promoter are the controlling factor in the success or failure of the investment. A common enterprise may exist even though there is no pooling of investors funds or interests Broad Vertical Commonality Look only to a connection between the efforts of the promoter and the collective successes or losses of the investors Strict Vertical Commonality Require a direct relationship between the success of the promoter and that of the investorsrequires the promoters and investors to share the risks of the venture Horizontal Commonality Requires a POOLING of investors fundsemphasizes the common enterprise among investors PARTNERSHIP AND LLC INTERESTS AS SECURITIES US v. LeonardSubstance/Economic Realities Test s had independent sales offices in order to solicit financing for movies, said they were taking 20% commission, really taking 50%. s claim that these interests are not securities SOLELY in Howey should not be taken literally Mainly looking to see if the scheme was being promoted as an INVESTMENT s state that this is a member-managed LLC and that the investors had control so it was not profit derived solely from the efforts of others and it shows on their DOCUMENTS Court says Substance/Economic Realities Test In reality, people were inexperienced in this and had very little to NO control NO Control in RealityThis is a security Limited Partners Limited partners are the types of passive investors in need of the protections of the federal securities laws. Because they do not have substantial managerial power in the partnership like the General partner does LLC Interests as Securities LLC offers its members the benefits of limited liability (corporations) AND a pass-through of tax income and losses (partnerships) Either member-managed LLC or manager-managed LLC Member-managed resemble GPs while manager-managed resemble LPs therefore in evaluating whether LLC interests are investment contracts, the analysis parallels that of GPs and LPs LPs deemed Investment Contracts and SecuritiesLack of Control Look to whether the investors control options are more theoretical than real. Therefore, Securities: Corporate Stock Limited Partnerships Interests in Manager-managed LLCs NOT Securities: General Partnerships Interests in Member-managed LLCs Landreth Case IF you can use the Forman Elements for finding out if it is a Stock then you do NOT need to go to a Howey analysis HERE, they had all the Forman characteristics of a stockYES, a security, No Howey needed HYPO: Thinking of making a stock buy by Sam himself or Sams Corp. will buy all assets/liabilities The Asset buy will NOT be a security The Stock buy WILL be a security REAL ESTATE AS SECURITIES GENERAL RULE: Standard real estate transaction in the form of a sale or lease of property does NOT involve the offer of a security. BUT, IF Promises of post-acquisition INCOME, OR Aspects of Management Control, OR Appreciation from future development of the ACTUAL issuer or seller Hocking v. Dubois (1989) Guy in Vegas wanted to buy a condo in Hawaii for an investment Dealt with an intermediary and was told to put his condo into a pool of other investors in a condo development and should expect profit Howey Although this is through an intermediary and in the secondary market it is still like Howey because he relinquished any right to enter or use the property Investment of Money YES, for profit Common Enterprise Yes, the purchase of real estate combined with a rental pool does evidence horizontal commonality Expectation of Profits from efforts of others Yes, he is inexperienced and lives far away, no day to day working Gets to go beyond summary judgment NOTES AS SECURITIES Difference on the treatment of notes by the two acts: 33 Act A security is any note BUT NOT a note that arises out of a current transaction that will mature WITHIN nine months 34 Act A security is any note BUT NOT a note with a maturity of LESS THAN nine months Therefore, any note with a maturity exceeding nine months would seem to come squarely within the statutory definitions of a security. Typical Attributes of a NOTE (1) Fixed, periodic Interest rate (2) Fixed Maturity rate (3) NO voting rights Reves v. Ernst & Young (1990) Company sold DEMAND NOTES, demand repayment at anytime, they go bankrupt REVES TESTFamily Resemblance Test (1) What is the Motivation of seller and buyer If Purpose of Seller is trying to raise money for the general use of a business or to finance investments If Purpose of the Buyer is interested in profit from the noteinvestment This would make it likely a security (2) Plan of distribution of the instrument Whether there is a common trading for speculation or investment. See if Marketed to a broad segment of the population (3) The reasonable expectations of the investor (4) See if there is any other risk-reducing agency or factor Start with the Assumption that if the maturity on a note is LESS THAN OR EQUAL to 9 months then it is NOT a security, based on definition section HOWEVER, if OVER, you can REBUT this assumption if you show that the transaction shows a family resemblance to judicially crafted exceptions: (1) Notes delivered in consumer financing (2) Home mortgages (3) Short term notes secured by a liento cover short term cash flows, for small business, want them to have cash (4) Character loanbased on good reputation with lender (5) Short term notes secured by accounts receivable (6) Note evidencing open account debt (7) Note evidencing loans by commercial banks for current operations. Here: (1) Co-op sold the notes in an effort to raise capital for its general business operations AND purchasers bought for an investment opportunity, profit (2) Offered and sold to a broad segment of the publicthis is all that is needed to satisfy this1600 investors (3) Advertised as investments to the public, thats what they thought (4) NO risk reducing factorsuncollateralized and uninsured AND would escape federal regulation entirely. Therefore, the note IS a security With HOWEYYou need ALL of the elements to pass With Revesthis is a FACTOR TESTa BALANCING TEST When talking about NOTESGo to Reves FIRST MATERIALITY 33 and 34 Act: Registrants must include in their registration statement such further MATERIAL information as may be necessary to make the required statement, in light of the circumstances, not misleading. Rule of Thumb: A misstatement regarding a financial statement item of 5 percent or less is NOT material. Basic Inc. v. Levinson (1988) Involves 34 Act 10(b) materiality requirement Basic says there are no merger talks, s sell stock, they actually have a merger, stock goes up Material Misrepresentation Rule: From TSC Industries (1) Substantial Likelihood (2) That a Reasonable investor would find it important (3) And would alter the total mix of the information available. s state that disclosing everything could ruin deals and mislead investor Court states RULE: Probability Relative to Magnitude Test Court states that materiality will depend at any given time upon a : Balancing of both : The indicated probability that the event will occur and The anticipated magnitude of the event in light of the totality of the company activity. Use Probability Relative to Magnitude Test for CONTINGENT EVENTS TRUTH ON THE MARKET (Sub-Set of Materiality) Wieglos v. Commonwealth Edison (1989) Investor in a Nuclear Reactor Company. Edison reports they will be building new nuclear reactor sites and this is how long it will take if everything goes right Outside analyst and newspaper reports stating that they will be delayed s bring suit because they are delayed Truth on the Market Defense RULE: Based on the information out there, that is commonly known, then people will have to understand that they cannot take what a company says is true when it is against all of the other outside information. Look at the objective nature of this situation, if there is enough outside information for a reasonable investor to know what is true. NO liability because there was outside information saying otherwise and their statements were optimistic and not misleading so it did NOT alter the total mix of the information available. PUFFERY (Sub-Set of Materiality) Eisenstadt v. Centel Corp (1997) Centel disclosed that they got two investment banks to help in their sale and that the sale process was going SMOOTHLY, ended up selling really low. Puffery is NOT Material Misrepresentation Everybody knows that someone trying to sell something is going to look and talk on the bright side, wouldnt influence a reasonable investor Mere sales Puffery is NOT actionable under 10b-5 HYPOyou have a sales lien and attorney tells you, you cannot sell this, and you say things are going smoothly THIS IS Material Misrepresentation and IS actionablethe sale is OVER If it is just ROUGH PATCH like Centelit is STILL GOINGok to puffery HYPOVirginia Bank Case Company says that we are receving high price for our stock BUT THEY KNEW that they were NOT from a report This is NOT pufferythis is CONCRETE Analyze it OBJECTIVELYwhat did they KNOW SOFT INFORMATION (Materiality) About information in the FUTURE, Forward Looking Statements The Bespeaks Caution Doctrine Kaufman v. Trumps Castle Funding (1993) Trump looking for investors for his casino, there is Cautionary Language in the contract Also it is very narrowly tailored and talks about the peak seasons of Atlantic City and the difficult business of operating a successful casino, no operating history, who knows how it is going to perform, capacity is huge, hard to fill, and profits and casinos generally were going to fall, permits Bespeaks Caution Doctrine (1) Cautionary language in the offering document NEGATES the materiality of an alleged misrepresentation or omission (2) Has to substantive and tailored to the specific future projections, estimates or opinions in the prospectus which the s challenge CANNOT BE BOILERPLATE HERENOT general, narrowly tailored cautionary languageNO Liability Safe Harbor for Forward-Looking Statements 27A to Securities Act, 21E to Exchange Act, For Private Rights of Actions ONLY (1) Bespeaks Caution Language (2) OR, if fails to prove that the forward-looking statement was made with ACTUAL KNOWLEDGE it was misleading Can be for ORAL forward-looking statements as well IF the listener can find the qualifying meaningful cautionary information. NOT available for IPOs, tender offers, and going-private transactions. Think about what Objectively, in common sense, would be MATERIAL Form 8-K: what needs to be disclosed: Among others: Insolvencybankrupt Change in controltriggering debt obligations Restrictive covenants Conflicts of interest Acquisitions Notice of de-listingshows that they failed to maintain certain requirements Waiving code of ethics Asher v. Baxter International (2004) For Material Misleading Misrepresentation You need to show: Materiality AND RELIANCE For Fraud on the Market DO NOT NEED RELIANCE, just materiality and a total mix effect Here, profits did not match expectations on press releases Safe Harbor applies here is cautionary forward-looking statementsBespeaks Doctrine Need NOT identify what ACTUALLY is going wrong HOWEVER, HERE, the cautionary language remained FIXED instead of changing with the changeshave to see if this is materialARGUE THAT IT IS Duty to Disclose Forward-Looking Statements (Materiality) Info MUST be Material AND An Independent Duty to Disclose the Info Comes from the Disclosure Rule of NO HALF TRUTHS Half Truths measured at the TIME THEY WERE DISCLOSEDno hindsight Panther Case Duty to disclose only if reasonably certain Desaigender Case NO duty to disclose speculative gains Kademian Case Other info available that makes Kademian public info NOT alters the total mix of info available. NO bright line test, have to use judgment when counseling FIBBERS: CANNOT be protected by cautionary language if you know the facts OR some very high degree of certainty that an event will occur Economy is bad and still expensive Louis Vitton is projecting huge gainslook to see if assumption makes sense Look at the level of CERTAINTY for Soft Information DisclosureManagement Integrity (Materiality) In the Matter of Franchard Corp Corporation owned by Glickmanpeople revered him and respected his reputation The IPO in this corporation was made based on his reputation DID NOT DISCLOSE ABOUT HIMSELF: Withdrawal of substantial amounts of cashNEED FOR CASH Diverting funds to personal accountLACK OF INTEGRIT OF MGMT Taking out loans to get more cashPossible CONTROL CHANGEcreditors Directors of the Corporation NOT liable Glickman was NOT honest with themthey did their best RULE: People invested on Reputation of MGMT, making their actions MATERIAL In the Matter of WR Grace NON disclosure of HUGE retirement benefits for Grace Jr. Managers did NOT question why this was left out of the disclosure reports RULE: If an officer or director KNOWS OR SHOULD KNOW that his or her companys statements concerning particular issues are inadequate or incomplete, They have an obligation to correct that failure. THE PUBLIC OFFERING 5 of the 33 Act BARS any offers to sell and sales of a security UNTIL a registration statement covering the security has become effective IN IT: Info about the securitys issuer, the security, the contemplated uses of the offerings proceeds, and the manner of its sale 11 Imposes liability upon the issuer, its principal officers, its directors, and its underwriters for any material omissions or misstatements in the registration statement when it became effective Outsiders ALSO liable for the parts they work on or certify UNDERWRITERS If a corporation needs to acquire funds: Can decide to offer securities and engage the services of broker-dealers to sell the securities to the public in either: Firm Commitment Underwriting: One or more investment banking firms (multiple=syndicate) Agree to PURCHASE the securities from the issuer and they resale $10 a share. Sell to underwriters for $9 a share. The $1 is the SPREAD and the underwriters get to keep this If they do NOT sell: They are personally hurt financially AND reputation is hurt MORE CONFIDENCE With this If you say you are FC but actually Best EffortsMaterially Misleading Best Efforts Underwriting Broker-dealers do NOT purchase the securities INSTEAD: agree, for a fee, to use their best efforts to sell the securities on behalf of the issuer at the offering price 3 different degrees of risk, threshold number of shares that MUST be sold before the Underwriters can CLOSE and get COMMISSION Straight ANY securities sold to investors remain sold; there is NO minimum amount that must be sold as a condition to the deal closingMOST COMMON Mini/Maxi a stipulated minimum amount of all the shares to be sold must be sold during a specific period of time before the offering can closeall sales are set in escrow until minimum is reached, if not, given back to potential purchasers All or None all the securities must be sold before the deal is completed The difference between that price and the amount received by the issuer is known at the gross spread. Gross spread is composed of 3 parts: The management fee for the managing underwriter The underwriting compensation received by the underwriters The selling concession received for any securities sold to the public by any broker-dealer participating in the distribution Documents preceding public offering Letter of Intent Represents the culmination of the preliminary negotiations and tentative understandings between the managing underwriter and the issuer Sets forth the relationship between the issuer and its underwriter until the underwriting agreement Agreement among the underwriters Formal understandings among the members of the syndicate Solidifies the managing underwriters authority The power to determine with the issuer the offering price of the securities The underwriting commission The concession/commission provided to dealers participating in the selling group Allotments 100,000 shares of 10 million shares to be soldentitled to 1% of the commission ALSO only has 1% of the liabilities Over-allotments Selling more than underwriting syndicate was obligated to sellhigh investor interest Known as a green shoe option to purchase additional shares from the issuer Bigger demand than expected FINRA limits the amount of over-allotments to 15% of the shares the underwriters are obligated to purchase. Anti-flipping Clause Occurs when shares in an IPO are quickly resold in the market at a profitthis places downward pressure on the price and impedes distribution Penalties given for this behavior Market Out ClauseMaterial Adverse Change (MAC) Permits the underwriters to withdraw any time prior to the public offering and/or settlement date if certain conditions ariseseen as poor form and is rarely used: The government or an SRO has imposed restrictions on the trading of securities in general There is a war or other national calamity There has been a material adverse change in markets There has been a material adverse event affecting the issuer REGISTRATION STATEMENT Information that must be included in the registration statement: (1) Information with respect to the Registrant Description of the registrants business, property, and management (2) Information about the distribution and use of its proceeds Underwriters in privity with the registrant must disclose the general terms of their agreement and their compensation The net expected proceeds of the offering must be disclosed If the registrant has plans for the proceeds, those plans must be disclosed (3) Description of the securities of the registrant Common Stock CASH FLOW: Residual rights and dividends LIQUIDATION: Residual, after everyone? VOTING RIGHTS: YES Preferred Stock CASH FLOW: Priority for fixed amount of dividends LIQUIDATION Priority VOTING RIGHTS NO BondDebt Securitiesmost common form of financing CASH FLOW: Right to fixed interest payment LIQUIDATION: Highest priority but is FIXED VOTING RIGHTS: NO (4) Various exhibits and undertakings that must be filed as part of the registration statement Registrants articles of incorporation, bylaws, any 10-K or 10-Q reports ONLY information within the first THREE categories must be reproduced in the prospectus Regulation S-K gives a detailed guide for what precisely must be disclosed 301 and 302 Require the registrant to disclose a wide array of other financial information about itself that supplements and emphasizes the information in its audited financial statements. 303 Requirement to include managements discussion and analysis of the registrants financial condition and results of operations. 408 Accurate filling out of registration statement that is expressly stated by the S-K AND any other information to make sure information provided is not materially misleading, no omissions. Attorneys, accountants, other experts opining, and underwriters all have a duty of due diligence. Cannot take things at face value, must dig in and get the truth Cannot ignore information that is blatantly available. Preparing the Registration Statement for Filing Issuer and underwriters can promote the offering before the registration statement is filed; HOWEVER, Section 5 imposes restrictions on the freedom of them to promote the offering before filing. DUTCH AUCTIONGOOGLE, NOT a FC or BE The Bidders Price the Stock Have a set mark of what you want to sell and you have an auction, anyone below the best does NOT get it CANNOT go really high just to be highestwill NOT be accepted it Can be ALLOCATED two different ways PRO RATAeveryone gets the same regardless of what they bid PROPORTIONALif you bid higher you get higher % SEC LETTER OF COMFORT 8 of the 33 Act The registration statement becomes automatically effective 20 days after filing. FILING THEN, Letter of Comment from SEC They review statement, state any deficiencies Failure to comply = formal STOP ORDER Issuers do NOT want deficiencies in their statements when effective Could lead to 11 liability for having misstatements in 5 statement Therefore, they want delaying amendmentpush back effective date until they fix it ALSO, can accelerate the effective date THE PRE-FILING PERIOD Section 5(c) Unlawful to offer to sell or offer to buy any security unless a registration statement has been filed for that security CANNOT condition the public or arouse public interest before making the actual public offering Under Section 5if regulation statement NOT in effect yet, CANNOT: (1) Transmit a PROSPECTUS (2) Deliver a security (3) Offer to sell (4) Offer to buy HYPO-- In PFPpresident tells investment club that they can get in ground floor of new company at 20 dollars a share There IS a motivation to sell The audience is an investment clubgoing to take this seriously This IS an offer to sellNO good in PFP Look to see if it is an offer to sell: (1) Audience (2) Type of infowhat kind of impact it will have on audience Selling a product vs. selling a security (3) Level of Distribution (4) Timingare they close to making a public offering HYPO-- non-reporting company, May 1st filing date February 1st, conference call to investors IS THIS AN OFFER Look at definition of offer--2(a)(3) There is an exemption for underwriters and syndicate negotiations NOW, look at definition of Underwriter--2(a)(11) If they BUY IT and sell it at their own risk NOT people that JUST get a commission THEREFORE, It is OK to solicit interest from FUTURE underwriters, even if they say nohave to be allow, how else would you get people to say yes, need to have negotiations HOWEVER, if it is JUST to someone that will get a commission ONLY, NO EXEMPTION and it WILL be an OFFERNOT ALLOWED TYPES OF ISSUERS Non-reporting Companies About to do S-1 filing, IPOsS-1 are no experience Unseasoned Reporting Issuers Exchange act reporting NOT able to do a S-3 Need a certain level of experience Need have timely filed forms Have to be up to date with filings Seasoned Issuers Reporting Able to file a S-3 Well-Known Seasoned Issuers (WKSI) Rule 405 NEED $700 million in equity/world markets in the hand of NON-affiliates OR, $1 billion in non-convertible debt that was issued in last 3 years CANNOT be Blank Check or Shell companies or Penny Stocks (