SECURITIES REGULATION CLASS OUTLINE

Chapter I: The Framework of Securities RegulationA.B. Securities Transactions, pp. 1-3

a. Issuer transactions : sales of securities from and issuer to investor (means of raising capital to develop/grow/etc.)

i. Private placement : most expedient form of issuer transaction (issuer select number of investor

1. Ex . Small partnerships adding new owners2. Ex . Large public corporations selling to one or more large financial institutions

ii. Public offering : offering of securities to a large number of diverse investors (also called primary distribution)

1. Underwriters : large syndicate of broker-dealers that sell large amounts of securities to be offered to the public

2. Initial Public Offering (IPO) : instance of company going public for the first timeb. Trading transactions : purchasing and selling of outstanding securities among investors (also

known as secondary distribution), resale privately negotiated or through public markets; ability to buy and sell securities will depend on whether there is a public market for those securities (securities markets)

i. Need for information: investors engaged in trading transactions are in need of information just as are those who purchase securities in a primary distribution (eg, determine offer price, sell price)

ii. Securities markets: facilities through which outstanding securities are purchased and sold

1. Types of markets: (1) bond market (mostly financial institutions, largest market, lots of trading in government bonds which are exempt from disclosure requirements) (2) equity market, and (3) derivative/options market

c. Function of Securities Markets : Securities markets serve 3 basic functionsi. Capital formation : bring together capital laden investors and capital needy businesses

through equity securities (common stock/preferred stock) or debt securities (bonds, debentures, notes, and commercial paper)

ii. Liquidity : Securities market bring together investors wishing to sell or liquidate their investments and new investors willing to buy; liquidity is the ability to readily sell an investment instrument and often determines whether an investor will purchase a security in the first place

iii. Risk management : Permits investors to minimize risk through diversifying and hedging their investments (overall risk of portfolio lower than that of its components); see derivative securities

d. Participants in securities markets :i. Investors : individuals who own securities directly/indirectly and institutional investors

that own securities as an entity or on behalf of others (trend toward institutional ownership in securities markets)

ii. Issuers : business corporations, federal agencies, state and local governments, and mutual funds that pool together investments

iii. Financial intermediaries : entities such as securities firms, investment advisers, investment companies, and investment banking firms that offer services and financial products also extends to accounting firms that audit financial statements of SEC filings and monitor the completeness/accuracy of company disclosures

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e. Honesty and not fairness in securities markets : Securities laws are designed to promote honesty in security dealings but NOT fairness, which means that the laws do not assure a favorable outcome to an investor (can still be legal and unfair)

i. Why is this the case : Link with honest markets and efficient markets, as more information in the market leads to more efficiency. Also when there are lots of market participants, one way to promote entry is through information, which assures investors that not rigged

C. The Legal Framework of Securities Regulation, pp. 3-18 a. The Federal Securities Laws :

i. The Securities Act of 1933 (Securities Act OR 33 Act) : Principally regulates primary market transactions; Administered by Division of Corporation Finance

1. Two Basic Objectives: a. Completeness : investors receive financial and other significant

informationb. Accuracy : prohibit deceit, misrepresentations, and other fraud

2. Requirements of ’33 Act : (1) Mandatory disclosure requirements (registration statements and prospectuses, heightened antifraud liability for issuers selling securities in IPOs) and (2) rigid process for issuers making IPOs (gunjumping process with quiet period)

a. Registration statement: Must include description of issuer’s business, property, management, and security to be offered; extensive financial information (revenues and earnings); mgmt must provide analysis of capital needs, solvency, and financial performance; any risk factors (eg, no preexisting market for security, issuer recently had substantial losses, or that nature of business proposes unique risks)

b. Prospectus: Much of the RS’s substantive information must also be disclosed in prospectus; purpose of prospectus to provide all material information necessary for investors to fully assess the merits of their purchase of the security (attempt to put investors on nearly equal footing with issuer and underwriters)

3. Exemptions : Issuer may sell limited number of securities through a private placement of sophisticated investors or through offshore transactions to investors outside the united states

a. Exempting small offerings is a balance between investor protection and capital formation objectives

4. Key policy questions : (1) Who is protected by the public offering requirements? and (2) Why should certain transactions be exempt from these requirements?

5. General structure of ’33 Act : DISCLOSURE and REGISTRATION REQUIREMENTS through registration statement and prospectus (S5) + exempt categories of securities (S3) + exempt securities (S4) + private remedies for materially false statements in registration statement (S11) + civil liability for violations of S5’s registration requirements/anyone who sells security with materially misleading statement + SEC powers to issue C&D’s (S8A) and prosecute violations in federal court (S20)

ii. The Securities Exchange Act of 1934: (Exchange Act or 34 Act) : Broader in scope than 33 Act; the main concern of the ’34 Act is the secondary trading markets and their participants; Administered by Division of Trading and Markets

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1. Main features of the ’34 Act: The ’34 Act revolves around three main things - (1) registration of certain companies that achieve public company status, (2) continuous disclosures for companies that achieve public status, and (3) Regulation of exchanges, broker-dealers, SROS (NYSE, ASE, NASDAQ) and market abuses

a. #1 - Reporting Requirements : 3 categories of companies required to report under the ’34 Act

i. 12b : Companies that have a class of securities listed on a national securities exchange

ii. 12g/12g-1 : Companies that have assets in excess of $10 million and that have a class of equity securities held by at least 500 persons

iii. 15d : Companies that have filed a ’33 Act Registration Statement that has become effective

b. #2 - Ongoing periodic disclosures for Public Companies : Annual Form 10-K filings, quarterly Form 10-Q filings, and episodic Form 8-K filings (use of EDGAR to make filings)

1. 10K: req. to include extensive description of the company’s business, audited financial statements for the fiscal year, and analysis of the position/performance of the company

2. 10Q: incl. unaudited interim financial statementys and mgmt’s analysis of financial operations and conditions

3. 8K: must be filed w/in few days of material development (eg, change in control, credit downgrade, acquisition/disposition of significant assets, resignation of director in dispute over policy

a. NOTE – Integrated disclosure for seasoned issuers: certain companies registering securities under ’33 act can fulfill disclosure demands by incorporating into the registration statement information from the ’34 Act filing requirements (eg., 10K information) interaction with ’33 and ’34 Acts

ii. Contrast the ’34 Act with ’33 Act: Once the timely filing are made, there is no additional requirement under the ’34 Act that the filings be forwarded to investors or other market professionals (unlike ’33 Act when must take the add’l step to give to investors/market professionals)

c. #3 – Proxy Solicitations, Tender Offers, Insider Trading: Requires full disclosure for shareholders voting, disclosure by anyone trying to acquire more than 5% of the company by direct purchase or tender, prohibits insider trading

d. #4 – Regulation of Exchanges, broker-dealers, and market abuses : Registration and regulation of secondary market participants such as broker-dealers, market makers, and national securities exchanges compelled under ’34 Act; also prohibits certain types of market manipulation; ALSO seek protection of capital markets and investors with 10b5 antifraud provision

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iii. Sarbanes-Oxley Act of 2002 (SOX) : Sets forth broad prescriptions for corporate governance, authorizes SEC to develop rules of professional conduct for lawyers, and regulates areas that have traditionally been provinces of the states, such as loans to officers and directors

1. Policy decision : OPPOSITE of disclosures required under the other securities acts and more focus on corporate governance; SOX shifts to corporate governance rather than disclosures

2. Main features of SOX : procedural and substantive safeguards for public companies as additional safeguards for investors (beyond disclosures required under ’33 and ’34 Acts)

a. PCAOB : Board established under SOX that oversees accounting industry responsible for auditing the financial statements of public companies

iv. “Other” Federal Securities Laws : Three “other” federal securities laws that impact the sale of securities in a national marketplace

1. Investment Company Act of 1940 : regulation of mutual companies and other investment vehicles

2. Investment Advisors Act of 1940 : regulates activities of those giving investment advice

3. Trust Indenture Act of 1939 : regulates the relationship of public bondholders and bond issuers, providing an indenture agreement with certain mandatory provisions

v. The Securities and Exchange Commission : independent nonpartisan agency created by ’34 Act, operates through 4 divisions: (1) Division of Corporation Finance (administers federal disclosure requirements); (2) Division of Trading and Markets (oversee secondary trading markets; securities exchanges, securities firms, SROS, MSRB, clearing agencies, transfer agents, etc.); (3) Division of Investment management (oversee investment management industry; administer Investment Company Act and Investment Advisers Act); and (4) Enforcement Division (administrative and court proceedings)

1. Purpose : Information access to investorsa. Interpret federal securities lawsb. Issue new rules and amend existing rulesc. Oversee the inspection of securities firms, brokers, investment

advisers, and ratings agenciesd. Oversee private regulatory organizations in the securities, accounting,

auditing fieldse. Coordinate US securities regulation with federal, state, and foreign

authorities2. Authority : §19(a) of 33 Act gives rulemaking authority and §28 gives authority

to SEC to grant exemptions from; 3. Rules and Releases : Rules have force of law under §14(a) of the 44 Act and §24

of the 33 Act; Releases, interpretations of rules or statute, usually do not have force of law

4. No-Action Letters : SEC Division of Corporation Finance responds to individual inquiries regarding the staff’s interpretation of the federal securities laws’ application to a specific transaction (does not represent official view of the Commission) company that is trying a new marketing or financial technique can ask if division would or would not recommend that the Commission take action against company if it engages in said new practice will not offer

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advice on availability of statutory exemptions from registration, whether novel RE interests are security, or hypothetical questions

5. Critical Perspectives of SEC : a. #1 - Overregulation of disclosure policy with excessive and

paternalistic focus on “investor protection” to the exclusion of equally compelling notions of cost justification and allocative efficiency

i. Rationale – Public choice theory : regulators rationally seek simply to maximize their own level of political support and frequently allocate wealth (regulatory subsidies/restraints on competition) to those groups that offer the most in terms of political support (regulation favors industry that regulators are supposed to oversee)

b. #2 – Disinclination to adopt bright-line tests, nonwithstanding the value of such an approach in promoting, planning, and reducing the incidence of litigation

i. Counterargument : don’t want to provide companies with blueprints for fraud

c. #3 – Dominance of lawyers in policy-making roles at the SEC, which leads to a natural bias towards the presence/enhancement of complex regulation, rather than its absence

b. State Securities Laws i. Blue sky laws : main difference from federal regulation (disclosure) is that include

merit-regulation, whereby qualification depends on convincing the state administrator of the substantive merits of an offering

1. Section 18 of the Securities Act : amended in 1996 to exempt from states’ registration requirements several categories of “covered” securities, including those listed on NYSE, ASE, and NASDAQ’s national market system

a. Result : states powers to compel registration of offerings under blue sky laws limited to relatively small offerings that are not made to sophisticated investors

c. Self-Regulatory Organizations : i. SRO’s and ’34 Act :’34 Act prescribes cooperative regulatory effort by SEC and four

types of SRO’s1. #1 - National Securities Exchanges: S5 requires all exchanges register as

national securities exchanges and S6 requires just and adequate a. NYSE, NASDAQ, smaller regional exchanges

2. #2 - National Securities Association: S15A called for the creations of a “national securities association” whose job it was to prevent fraudulent and manipulative acts to promote the just and equitable trade practices among over the counter broker-dealers

a. FINRA (Financial Industry Regulatory Authority) oversees over the counter market

i. 15a1 : broker-dealers must register with SEC if offer/sell/purchase securities

ii. 15b8-9 : unlawful for registered B/D who is not a member of national securities association to make any securities exchanges unless they solely occur on an exchange of which he is a member

3. #3 - Registered Clearing Agencies 4. #4 - Municipal Securities Rulemaking Board

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D. Mandatory Disclosure, pp. 243-49, Problem 4-49a. Mandatory disclosure and United States’ Competitiveness :

i. Factors to consider that hamper US competitiveness : Different market today than in 1933/34 that suggests we should legislated more relaxed requirements

1. #1 - Evolution of the market of who is the owner of U.S. Securities : evolution from a retail market → institutional market.

a. (1) 2008 Q2, individual ownership of stock 23.5%; (2) Institutions diversified, loss in one transaction won’t have a big impact on them; (3) Large institutions have stock on an ongoing basis. If they bring an action, they’re bringing it against themselves because they will be a defendant any time they’re a plaintiff.

b. CONSIDER : What about the 23.5% retail plaintiffs? Do we set up different standards for individuals vs. institutions?

2. #2 - Companies are unhappy operating under US regime, and one element in all of that is liability.

a. (1) Foreign companies don’t want to come here; (2) Foreign companies that are here want to leave; (3) U.S. companies don’t want to be here.

3. #3 - Direct securities class actions against companies did not exist in 1934, but they do now

a. Liability problem: Combining easier causes of action with a class action ratchets up this liability problem, which is a problem for U.S. equity markets one of top reasons senior management doesn’t want to use our capital markets is the securities class action device

i. In 2007, the SEC passed new rules that made it easier for companies to delist (shows pent up demand to leave)

ii. Other reasons accounting for deterioration of U.S. competitiveness? 1. Other markets are better (weren’t as big a factor in ’33 and ’34) 2. Fact that our companies are stuck here puts them at a comparative

disadvantage in comparison w/ foreign companies, who can avoid this liability. b. The Debate Over Mandatory Disclosure

i. Incentives to disclose voluntarily: 1. Traditional view : Mandatory disclosure is a means to break the managers’

monopoly over corporate information; feel disclosure necessary because owners/managers interest in maximizing their utility not always coincident with their stockholders’ desire that firm value needs to be maximized (classic problem with separation of ownership)

a. How to deal with this problem : i. #1 – Compensation incentives : Owners/managers contract

such that will act in an optimal manner on behalf of the firm stock options, bonus arrangements, other modes of compensation linked to the changes in value of the firm’s stock

ii. #2 – Monitoring the manager’s behavior: use of outside directors, certification of accounting reports, takeover of underperforming management proxy contest/hostile takeover)

b. Consider empirical data : Says that financial disclosures reduce the riskiness that surrounds the pricing of securities in the marketplace

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because they remove the uncertainty regarding the firm’s financial position and performance

2. Market-based position (Easterbrook) : Market will adjust for inadequate disclosure by discounting the price. Even though market can’t penalize what it doesn’t know; the market penalizes when it finds out (large penalty - average for stock drop for late disclosure is 42%).

a. Optimum or adequate disclosure if market-based? : Not an automatically self-enforcing system but we’re going to get the level of disclosure that the market wants.

ii. Creating Incentives : Concerned where issuer has an incentive either to omit or misrepresent the truth (won’t be repeat players who rely on reputation but fly by night companies don’t care about reputation and have less of an incentive to reach optimum level of disclosure).

1. Arguments FOR mandatory disclosure: (1) issuers have lowest cost of providing the information, (2) skeptical that managers will provide info with same detail/promptness if not required by law to do so (management and investors have different motivations if left to the market), (3) doubt that employment contracts can sufficiently align managers interests with shareholder interest (with stock options, etc.), (4) lack of securities laws would lead to under production of information because information has the characteristics of a public good (lead to duplication and waste of resources because everyone would protect their own information and would need more resources to discover same information by multiple parties BUT info is essentially a subsidy for professional securities analysts since don’t have to discover this information); (5) reassurance of oversight (bolsters investor confidence in securities markets since assured of gov’t oversight and protection); and (6) liability for securities fraud (although disagreement that ex ante required, all agree that ex post for antifraud liability is appropriate government intervention)

2. Arguments AGAINST mandatory disclosure: (1) High quality firms will engage in more disclosure than low quality firms to distinguish in marketplace, (2) high quality firms would distinguish from low quality by outside auditors, paying dividends, using reputable IB’s, (3) market would compel that amount of disclosure that it wishes to have

3. Costs of mandatory disclosure a. #1 - Companies are short-sighted as a result of having to report so

frequently: i. Quarterly earnings guidance (expectations of earnings for the

next quarter): if you don’t reach your projection the market hammers you and you won’t make decisions risky to the following quarters good for investors, bad for business decisions capital allocation.

ii. BUT just need to EXPLAIN : Explain yourself to the market (risks and why you still think its worth it). If the market believes that it needs to give you some time to see if it works out, then you’ll be okay.

b. #2 - Disclosure is costly c. #3 - Market should demand optimal disclosure anyway

4. Pros of mandatory disclosure a. Provides more information to the markets

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b. Omissions won’t be covered otherwisec. Instills more confidence in capital marketsd. Allows for more liquid market and free exchanges (broad sense)

Chapter 2: The Definition of a Security

RELEVANT STATUTORY PROVISIONS – DEFINITION OF SECURITY

STATUTE STATUTORY DEFINITION PLAIN MEANING’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, . . . investment contract . . . or, in general, any interest or instrument commonly known as a “security”

Main issues arise in determining (1) what is an investment contract, and (2) when is something that nominally falls into an enumerated category under securities laws (eg, notes) actually not a security), which would permit the security to be excluded by the language used “unless the context otherwise requires“

’33 Act – 3(a)(3) 2a1: Security includes “any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness . . .”3a3: Exempts from registration a note that “arises out of a current transaction or the proceeds of which have been or are to be used for current transactions “ and that will mature within 9 months

Exempts from registration requirements notes that will mature within 9 months under 3a3, issue of whether the note will mature within 9 months but does the “context otherwise require” exemption from securities laws?

’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…

Exempts from registration requirements notes that will mature within 9 months under 3a3, issue of whether the note will mature within 9 months but does the “context otherwise require” exemption from securities laws?

A. What is a security: a. Generally : Includes common stock and publicly traded bonds; courts have found that security

includes investment schemes relating to earthworms, chinchillas, and warehouse receipts for Scotch whiskey

i. Listing in the statutory definition not the end of the analysis : Things not literally listed in the statutory definition might still be included (e.g., investment contracts) and things literally listed may or may not be included (e.g., stock in Forman not, but stock in Landreth was)

ii. Broad definition of “security” under federal securities law : Securities laws reach novel or irregular devices if widely offered or dealt in under terms or courses of dealing which established their character in commerce as “investment contracts” or as

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“any interest or instrument commonly known as a security” (Joiner Leasing, 1943, holding offering and sale of an assignment of oil leases as security)

Form of the investment not dispositive : Application of the securities act depends on the economic realities underlying the transaction and not the name appended thereto (Forman). The name has relevance to the consideration of whether investors expected reporting protections, but the name is not dispositive.

1. Ex. - Calling it “stock” doesn’t automatically make it a security : Forman court looked to Howey investment contract test rather than accepting that it was stock. Co-op City “stock” was not an investment contract because the primary purpose of the contribution of money was to find housing, not to make financial gain.

a. Rationale of Forman : Congress intended securities laws to apply only if the economic realities of the situation dictated that they apply, and the tenants’ shares lacked traditional characteristics of stock (no pro rata dividend, non negotiable instrument, no voting rights, no appreciation of the stock)

b. Why it matters whether something is a “security” : i. YES, security : Transactions involving securities are subject to registration mandatory

disclosure, and heightened antifraud liability, while intermediaries of securities are subject to SEC rules and oversight

1. Regulatory requirement if security: (1) Registration of public offerings of securities, (2) disclosure by those who publicly offer securities, (3) registration by companies who securities are publicly traded, (4) disclosure by those who offer to buy publicly traded securities, (5) limits on trading by those who have inside information, (6) disclosure by insiders who hold certain amts of publicly traded securities, (7) registration of intermediaries who sell securities, (8) administrative/judicial liability for violations of securities laws, and (9) antifraud protection for those who violate securities laws

ii. NO, security: Non-security transactions do not receive regulatory attention involving disclosure, registration, and antifraud liability and are exempt from the regulatory requirements

c. Doctrinal considerations: define investment contracts and consider the “context”i. (1) When does an unorthodox investment fall within the catchall terms, principally

“investment contract”? (Howey)ii. (2) When is something that nominally falls into an enumerated category under

securities laws (eg, notes) actually not a security, which would permit the security to be excluded from regulation by the language used “unless the context otherwise requires“ (Forman/Landreth)

1. CONSIDER : cases turn on whether the investors have entrusted their money to another’s management and whether they face practical difficulties in supervising the management

2. ECONOMICS : Definition of “security” influenced by (1) agency costs of investors with monitoring those who manage their money and (2) collective action problem of investors in coordinating supervisory control

3. REMEMBER : Securities laws reach novel or irregular devices 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)

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d. Policy question : Should securities regulation be mandatory or should be participants in the securities market be allowed to decide if the regime applies?

i. Narrow definition of security : If “security” is narrowly defined, entrepreneurs could seek to raise capital without the protection and high cost of securities laws by renaming the instruments

ii. Expansive definition of security : Law must have expansive definition of securities that focuses on the ECONOMIC REALITIES of the situation and ignore the form

iii. Number of investors + desire for information : Application of the securities laws may be most justified when we have a number of investors who desire common information through mandatory disclosure

B. Investment Contracts, pp. 19-25, 28-45, Problems 2-1, 2-2, 2-5 a. Generally : Catch-all category for “security” is “investment contracts”, which is not defined by

the statutei. Type of investments when Howey test applies: Apply when the investment separates

OWNERSHIP from CONTROL “investment contract” definition identifies investments in which investors are counting on others to manage the enterprise that will produce financial returns on their investments

1. Rationale: In situations where ownership separate from control, mandatory disclosure and higher liability standards of FSL will ensure that investors allocate capital to its highest valued uses

ii. Considerations that courts take into account when defining “investment contract”: (1) Economic realities of the situation, (2) Some labels determinative and don’t require examination of the economic realities (such as stock if it has the traditional characteristics of stock), and (3) economic reality important, but courts’ desire for certainty sometimes limits its influence

iii. When has applied: (1) Sale of row of 48 citrus trees when cultivation, harvesting, and marketing handled by affiliate of a seller (Howey); (2) Sale of earthworms when seller promised to repurchase and market them to farmers (Smith v. Gross); (3) Sale of participations in a pyramid scheme when seller conducted promotional meetings and the buyer received a “commission” for each new person brought into the scheme (SEC v. Koscot Interplanetary Inc.

b. Howey test applies to “investment contracts”: The test for an investment contract, which has no meaning in the commercial context and is a construct of legislators and judges, is “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others” (Howey) 4 factors

i. Howey restated: Presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others (Forman)

c. 4 factors in Howey test for whether “investment contract” and hence “security” :i. #1 – Investment of Money:

1. Investment: Investor must put out consideration with the expectation of gaining a return, as the motive for investment must be pecuniary profit and not consumption or use, even if there are certain economic savings that go with consumption (i.e., below market rent, see Forman)

a. Forman tenants had to give shares back at purchase price, could not have been mixed intent for investment AND housing, and if there had been, could have made a case for it being a security.

b. In Int’l brotherhood of Teamsters v. Daniel, no investment contract existed when employers under CBA made contributions to employees’

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retirement plans b/c “employee selling labor to obtain a livelihood, not making an investment” (interest in pension plan does not constitute a security)

i. Daniel said that an investment may include the transfer of goods or services in return for a security investment, but a pension plan is not an investment

ii. Rationale: (1) Pension insignificant portion of entire compensation package, (2) Motivation to accept employment has little relation to pension plan, (3) Economic reality in that selling labor to make living not invest, (4) Benefits not correspond to time worked

iii. POLICY CHOICE – securities regulation cares about impact of securities markets: Courts should care about transactions that are close to capital markets, and a pension plan is not one of those transactions. Where there is use of low value, non-monetary considerations, this may indicate that the transaction does not implicate the capital markets and investment should be considered a security

2. Money: Securities Act covers all forms of “money” (cash/check/ bond)ii. #2 – Common Enterprise: Multiple investors have interrelated interests in a common

scheme (horizontal commonality) or if a single investor has a common interest with the manager of his investment (vertical commonality)

1. Horizontal commonality (most common approach): Requires the pooling of funds among multiple investors and an apportionment of profits from the enterprise to investors based on their pro rata share in the pool (returns and losses must correlate with the size of the investment)

a. Interrelatedness among investors matters: HC test focuses on the interrelated interests of the investors in a particular scheme (multiple investors must have common interest amongst themselves)

b. Question to ask with HC: Is there a common enterprise among investors, rather than the common enterprise between a promoter and an investor?

c. What “horizontal commonality” really means: (1) More restrictive approach that covers fewer transactions; (2) Requires pooling of investors’ funds (but can argue that just because pooled interests, doesn’t mean there is horizontal commonality, see Life Partners and life insurance scheme); (3) Can have fixed/variable rates of returns, but usually involves pro rata distribution

2. Vertical Commonality: Fortunes of the investor are interwoven with, and dependent upon, the efforts and success of those seeking the investment or of third parties (Turner/Koscot Interplanetary). Investors do not necessarily receive the same return relative to their investments but connected based on their dependence on a common promoter or manager.

a. Investors + Promoter: VC test focuses on the community of interest of an individual investor and the manager of the enterprise, as the investor(s) must have a common interest with the manager of his investment

b. Question to ask: Are the activities of the promoter the controlling factor in the success/failure of the investment?

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c. Determinative factor (usually) : Whether promoter’s activities are the critical factor in the investment success/failure

d. What “vertical commonality: really means: (1) Emphasizes the relationship between the investors and the promoter; (2) Turns on; (3) May exist even though there’s no pooling of investors’ funds/interests; (4) May arguably exist even if there is only a single investor

e. Two types of vertical commonality – broad and strict i. Broad vertical commonality : Requires only a connection

between the efforts of the promoter and the collective successes or losses of the investors

1. BVC and risk sharing: Promoter/manager does not share in risk or returns of the investors (compensated with flat fee)

ii. Strict vertical commonality : Requires a direct relationship between the success (as opposed to the efforts) of the promoter and that of the investors (must share the risks of the venture)

1. HVC and risk sharing: Common promoter shares in the returns and is exposed to the risk of the investment

3. Common Enterprise Example – discretionary trading accounts manager by securities brokers and commodities traders:

a. Type of Accounts : Vest a broker/investment adviser with discretionary authority to execute trades for customers

i. Broad vertical commonality : common enterprise MAY exist because of investors’ dependence upon the brokers expertise, even if broker does not share financial risks

ii. Strict vertical commonality: DENY existence of common enterprise if the broker may continue to profit through the commissions, even if the investor is losing money

iii. Horizontal commonality: MAY deny common enterprise exists since multiple investors not joint investors in the same investment enterprise and no pooling of investors funds

4. Compare HC vs. VC : Under HC, each investors return depends on common factors (how well the pool does); Under VC, return of each investors is dependent on common factors and individualized factors

5. Application of “common enterprise” test in federal courts : a. Must meet either HC or VC : no courtb. Must meet VC: CA5 and others, most “investor friendly” testc. Must meet HC: CA7, less “investor friendly”d. Must meet HC AND VC: no court does this

iii. #3 – Expectation of Profits: Expected return must come from earnings of the enterprise (not merely additional contributions from other investors), and this return must be the principal motivation of the investor

1. Profits: Defined as (1) capital appreciation OR (2) appreciation from initial investment

2. Consumption vs. investment : If motivated to purchase by desire to consume the purchase than securities laws do not apply and will not meet “expectation of profits” prong (Forman). MUST distinguish schemes where place $$ for investment vs. those involving consumption (eg, tenancy)

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3. Compare investment of $$ (prong #1) vs. expectation of profits (prong #3) : Investment of $$ prong (#1) focuses on motivation behind investors decisions (if capital market a motivation, then yes security and if not, then not security), and profits (#3) defined more narrowly than investment of $$ (capital appreciation and participation in earnings)

4. Courts make no distinction between variable and fixed returns: There is no distinction between variable and fixed returns for purposes of determining the presence of profits under prong #3 (SEC v. Edwards)

iv. #4 – Solely (predominantly) From the Efforts of Others : Efforts of the manager must be predominant, and the test is whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise

1. Question to ask: Does the promoter or investor provide essential managerial efforts?

a. Must have “significance: “Efforts of others” have to be undeniably significant/predominate, or be the essential managerial efforts that affect the enterprise’s failure/success (Turner CA9 and Koscot CA5)

2. Reading of the word “solely” : Court do NOT conduct literal reading of the word “solely” when determining whether it is an investment contract. Minimal investor effort will not exclude investment scheme from IC definition applying

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

3. Rationale : Fact that investor engages in minimal activities irrelevant to rationale for applying securities laws, because if the activities are minimal, the promoter will still have informational advantage over the investor (eg, if pick one orange in grove, won’t have insight into business at all and investors still face collective action problem to get information from the promoter). BUT if investors are managing the business, they will have enough information to make an informed investment decision (eg, info on business, finances and future plans)

4. Case law interpreting “profits from the managerial efforts of others”: a. #1 - Franchise or distributorship arrangements: Generally require a

level of activity by investors to defeat classification as investment contracts

i. Significant investor activity = No IC: Montgomery Ward where agents sell and eanr commissions based on items sold would be IC since depend on significant efforts by investors/agents of company (Crowley v. Montgomery Ward, CA10)

ii. Illusory investor activity = IC : 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. Aqua-Sonic Products Corp., CA2)

b. #2 - Timing of promoter’s efforts may be relevant to the investment K analysis :

i. Promotion efforts done BEFORE purchase of security = NO IC – See Life Partners (DC Cir.): Fractional interests in life insurance policies of the terminally ill (viatical settlement contracts) sold to investors, pool would purchase LI policies for cash and pool

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members receive insurance policies after the deaths of the insured, if alive paid the insurance policies, after sell LI policies, Life Partners have no interests in the pool failed the “efforts of others” prong, as although passive investors, returns on the viatical settlements depended on life span of terminally ill and did not depend significantly on the post purchase services provided by Life Partners or its agents (“near exclusive” determinant of how well the pool performed was how long the insured survived)

1. NOTE: Pre-purchase services of Life Partners not, standing alone, constitue efforts of others for the “efforts of others” prong of the test

2. Role of administrative functions : 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

3. Pre- and Post-sale Efforts Distinction : Rejected in latter cases (CA11, Sec v Mutual Benefits) that no basis for excluding pre purchase managerial efforts from IC analysis

C. Real Estate, pp. 58-59 a. RE Transaction MAY be security : Std RE transactions involving sale/lease of property is not a

security, but RE transaction may be security if seller/affiliates offer collateral arrangements offering post-acquisition income

i. Resort Condos NOT occupied by purchasers: Factors to consider include (1) Condos + rental arrangement sold with emphasis on economic benefits to the purchaser to be derived by the managerial efforts of promoter/3rd party for the condo units; (2) Offering of participation in rental pool arrangement; (3) Rental arrangement where purchaser must hold his unit available for rental for any part of the year, must use exclusive rental agent, or is otherwise materially restricted in his occupancy of the rental unit

ii. Appreciation based on future developments: Presence of security may be asserted in RE promotions that emphasize the appreciation based on future development efforts (of the promoters or others) rather than income through property management generating rental income

1. Ex. – Sales of residential lots promoted with representations concerning future development activities: Unless development activities will be accomplished by the promoters, however, unlikely that sales of undeveloped RE will involve securities (Rodriquez v. Banco Rental Corp., CA1, security might have existed if defendant promised along with the land sale to develop cmty themselves but did not since only left false impression that would be developed through natural forces)

a. Deliver title not enough: No security when developed only under contractual obligation to deliver title (Woodward v. Terracor, CA10)

b. Roads/improvements not enough: Building of roads and other improvements not managerial efforts contemplated by Howey (Davis v. Rio Rancho Estates, SDNY)

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c. Minimal managerial functions not enough: Not security unless real burden of mgmt and development rests on the developers (Aldrich v. McCullough Properties, CA10)

D. Associational Formalities, pp. 45-57, Problems 2-6 and 2-8. a. Stock as a security:

i. Forman and stocks which do not bear the traditional characteristics of stock : Suggests that IC and stock should be collapsed into one test based on focus on economic realities

ii. Landreth and stocks which bear traditional characteristic of stock: Stocks bearings the traditional characteristics of stock are presumptively securities (1) right to receive dividends contingent upon the apportionment of profits, (2) negotiability, (3) ability to be pledged or hypothecated, (4) conferring of voting rights in proportion to the number of shares owned, (5) capacity to appreciate in value, (6) Reasonable expectation of profits to be derived from the entrepreneurial or management efforts of others (profits = capital appreciation or participation in earnings resulting for use of investors funds)

iii. Howey does not apply to “stock” : Howey applies only to ICs and primarily unusual instruments and should not apply to commonplace instruments such as stock

b. Sale of business doctrine: i. Sale of business doctrine is “dead letter” : Sales of all or substantially all of the stock in

closely held corporations not exempt from the federal securities laws, as the stock possesses all the usual characteristics of a stock in acquisition of a company (Landreth Timber)

1. Policy Choice : Securities laws protect acquisition of 100% of a company or asset – BUT do we really need to protect in those situations??

2. How to purchase an entity without buying the stock : (1) Purchase and Assumption Agreement, using a corporate shell (Shell corporation, funded by the buyer, buys the assets and liabilities of the original company) or (2) Don’t call it a purchase of stock since Landreth relies narrowly on name and official structure as stock

c. Partnerships and Limited Liability Company Interests as Securities: i. Generally : Not addressed directly in the statute, so issue is usually presence of an

investment contract (apply Howey test) and whether investors are dependent for their profits on the efforts of others.

1. Empirical evidence : Few cases actually do treat P-ship interests as securities, but (1) Plaintiffs have a better chance if they’re LPs than if they’re GPs; (2) Cts tend to see passive LPs as parties deserving Securities Laws protections Latitude that actually allows LPs broad range of participation before they lose these protections

ii. Partnership interest as securities (Tucker, CA5) : Partnership interest is a security if party can establish: (1) no legal control; (2) no capacity to control; or (3) no practical control

1. Limited Partnership NOT “investment contract” – Steinhardt Group v. Citicorp (CA3): When LP had meaningful control: veto power, removal of GP, material actions required its approval not a security since the sophisticated limited partner was not a passive investor under Howey

2. General partnerships NOT “investment contracts” : Power to control provides investors with a degree of protection (if partnership business suffers, they can remove the manager)

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a. Rationale : If have control and negotiate for control, can (1) negotiate for disclosure and (2) those who negotiate for control of a particular investment unlikely to consider the range of passive investments as alternatives (transaction has fewer impacts on capital markets)

b. Compare LPs vs. GPS” : GP’s face unlimited liability, own fortunes are at stake so will not be IC’s, whereas LP’s limit exposure to the extent of investment and therefore can be ICs (but see Steinhardt)

3. Limited Liability Company and “economic realities” test: What matters more than the form of an investment scheme is the “economic reality” that it represents. The question is whether an investor, as a result of the investment agreement itself or the factual circumstances that surround it, is left unable to exercise meaningful control over his investment (United States v. Leonard, CA2)

a. Case law – no IC : Although organizational documents could lead to believes that members expected to play an active role, the investors retained no meaningful voting right, few investors actually served on financial/mgmt committees, such that nonwithstanding the language in the organizational documents suggesting otherwise, there was no “reasonable expectation” of investor control (United States v. Leonard, CA2)

b. Case law – yes IC: Where investors sat on his LLC’s board of managers, executive committee, and served as the treasures, no investment contract was present because there was actual investor control, and the positions allowed the investor to oversee his interest such that other managers did not harm his investment (Robinson v. Glynn, CA4)

c. Case law – yes IC: Although investor a “babe in the woods”, his control of the checking account and his ability to veto a mortgage of partnership assets were sufficient to rebut the investor’s claim that he was a passive investor (Endico v. Fonte, SDNY)

4. Courts generally look beyond the agreement: For both partnerships and LLCs, the issue becomes whether the investor control options are more theoretical than real

a. Where control more theoretical than real : Power to name MGP must be turned in with capital contributions, partners did not have ability to remove MGP, investors geographically dispersed such that power to remove MGP illusory, abuse of ballot process by MGP (SEC v. Merchant Capital, CA11)

E. Notes, pp. 65-80, Problem 2-11 a. Compare ’33 Act and ’34 Act Treatment of “Notes”:

i. 33 Act: Registration exempt from note that matures within 9 months based on reading of 2a1 (brings notes within coverage) and then 3a10 (exempts from registration requirements but not the antifraud provisions)

1. 2a1 : Security includes “any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness . . .”

2. 3a3: Exempts from registration a note that “arises out of a current transaction or the proceeds of which have been or are to be used for current transactions “ and that will mature within 9 months

ii. 34 Act: Inclusion and exclusion of notes occurs in 3a10 and excludes from coverage notes with maturity of less than 9 months

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1. 3a10 : Describes a security as “any note” and then excludes from coverage of the statute those notes with maturities of less than 9 months

iii. What does this mean for coverage of notes under ’33 and ’34 Acts : At least in theory, short term notes are exempt altogether from the ’34 Act but still subject to the provisions of the ’33 Act other than those that deal with registration

iv. Issue with coverage of “notes” and other debt instruments under securities laws : Should financial instruments with the traditional characteristics of debt – fixed maturity date, a fixed and certain interest payment, repayment of principal at the end of maturity – be presumptively treated as securities?

1. Problem: Would be disaster if treated both stocks and notes similarly, but no indication in securities laws that intended to treat differently (eg, problems with home loans and other consumer loans if were subject to the securities laws for those transactions, and not related to capital markets as with Landreth)

b. Family Resemblance Test (Reves v. Ernst & Young) : Permits an issuer to rebut the presumption that a note is a security if it can show that the note in question “bears a strong family resemblance” to an item on the judicially crafted list of exemptions . . . or convinces the court to add a new instrument to list (Reves).

i. Analysis under Reves: If note and has maturity more than 9 months (outside exclusion of statute), presumed to be security unless family resemblance to certain instruments that have been held by court not to be securities (even though notes)

1. Step #1 - Rebuttable presumptions that every note is a security unless it falls into an exception (short term debt with a maturity of less than 9 months).

2. Step #2 – See if the note falls under the “list of notes” that are obviously not securities and fall outside the definition (eg, notes related to consumer financing, securing home mortgages, and certain short term business loans related to the working capital or current operations of a business)

3. Step #3 – Attempt to rebut presumption that security. Notes bearing any resemblance to these type of “excluded” notes can rebut presumption that they are a security. Issuer can rebut the 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 the exceptions

4. Step #4 – If note not sufficiently similar to an item on the list, or for new transactions, consider whether it resembles the items on the “excluded note” list by using the following factors:

a. Motivation of the parties (investment vs. commercial/consumer purposes): Motivations of a reasonable seller and buyer of the note, in particular whether the seller (borrower) desires capital to fund consumption for a commercial purpose (in which case the instrument is not a security) or the purpose is to fund substantial investments or for a general business purposes (security)

b. Plan of distribution : Plan of distribution to determine whether there will be “common trading for speculation or investment”

c. Public expectations: What are the reasonable expectations of the investing public

d. Risk-reducing factors, such as an alternative regulatory regime: Are there other factors that significantly reduce the risk of the investment (such as another federal regulatory regime), thereby rendering the applications of the securities laws unnecessary

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ii. Reeves rationale: Notes redeemable at any time (could be either more or less than 9 months) so need to look at the factors (1) Investment motive since sold to anyone, not just coop members, (2) Plan of distribution = 22,000 note holders, (3) Advertising represented as investments and not as an opportunity to save to coop, (4) No risk reducing factors present since unsecured and uninsured notes

1. Howey vs. Reves: a. Howey only applies to investments K’s, and notes do not required the

same special treatment as stockb. Reves balancing test that looks at motivation of borrower and

common trading market (not common enterprise) c. Howe must be meet all 4 prongs, focuses only on the investment

motivation of the investor, common enterprise and not necessarily common market (looks at common return)

2. Why 3a10 exclusion does not apply : Although could get $$ back immediately, might not make demand for many years so since not necessarily short term, the 3a10 “9 month” exclusion did not apply and MUST apply the family resemblance test

3. “Context clause” exception: This is a case about “unless the context otherwise requires”, as this does not fall within 3a10 but could have been under the “context clause,” although the court did conclude it was security so the CCE did not apply in Reves

c. Commercial Paper Exemption in ’33 Act: 3a3 exemption for notes that notes of which the proceeds are to be used for “current transactions” and whose maturities do not exceed 9 months applies only to commercial paper, which is generic term used to describe unsecured promissory notes issued in large denominations by very large and financially sound companies and purchased by institutional investors

d. Alternative Regulatory Regimes: Phrase “unless the context otherwise requires” in 2a1 and 3a10 excludes some instruments that would otherwise qualify as securities b/c presence of an alternative regulatory regime protects investors

i. Daniel (SCOTUS): ERISA protects compulsory pension plansii. Marine Bank (SCOTUS) : COD not security since FDIC, federal banking laws sufficiently

protect the investorsiii. Holloway (CA10) : State regulation of the transaction not a factor in determining the

application of remedial securities laws, but federal banking would beiv. Wolf v. Banco Nacional (CA9) : Federal government regulation provided same degree of

protection as US regulation for banking such that COD not a security 1. When do we care about alternative regulatory regime?? : Only another federal

regulatory regime will suffice to exempt certain instruments from securities laws

F. Derivatives and Securitization, pp. 80-81, 85-91a. Derivative securities and synthetic investments: Financial instruments that derive value from

other assets to which their values are linked (underlying assets may be stock, stock index, foreign currency, etc.)

i. Call Option : Gives holder right to purchase a fixed number of shares for a specified price during a defined period of time

ii. Swap: negotiated arrangement b/w 2 parties in which each promises to make a payment to the other, with the payments occurring at different times and determined under diff. formulas

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iii. Synthetic transactions: Contractual agreement b/w investor and counterparty (eg, bank) that gives the investor the economic equivalent of a position in a certain security or option on a security without the investor actually buying that security or option

b. Commodity Futures Modernization Act : Removed from CFTC regulation wide range of swap arrangements and OTC derivatives that involve highly sophisticated individuals and not traded on an exchange now have MOU b/w SEC and CFTC to facilitate regulation of novel derivative products since lines blurred b/w the two regulatory bodies

i. Credit derivatives: Derivative instrument tied to an underlying bond, loan, or similar financial asset most common type is credit default swap

1. CDS: enables two parties to speculate on the credit risk of a third party (unregulated form of insurance against default), only effective if confidence in the ability of the counterparty to meets its obligations under the CDS CDSs are NOT securities and market unregulated

c. Separate securities and pass throughs : Not all income producing instruments are securities (eg, bank COD and note issued in consumer transaction), BUT the activities of an intermediary in packaging financial instruments may make a security out of something that is not (see Gary Plastic, CA2, Merril Lynch offering customers CODs that were securities because active in screening and negotiating with banks and maintained a 2ndary market for the CODs, such that a significant portion of the customer’s investment depends on Merril Lynch’s managerial and financial expertise)

i. Examples of intermediary creating securities out of something that is not: Securitization of mortgages, government securities, bank CDs, and corporate accounts receivable

ii. Pass through analysis: MAY constitute a security under an investment contract (Howey) or note (Reves) analysis Zolfaghari, CA4 says pool of MBS are securities since depend on the mortgage make in choosing what ends up in the pool, which will then impact the amount of money made on the investment

G. Policy Questions – Why Do We Care Whether Something is Defined as a Security when dealing with unique financial instruments?

a. Reason #1 – Definition determines when securities laws apply : Securities Laws make sense for certain transactions: (1) related to capital markets (Howey test, with $$ + return of profits limits application to capital market transactions) (2) in which participants face collective action problems in obtaining commonly desired information, and (3) intangible nature of the investment may pose large information problems for the investors Howey test best capture these intuitions

b. Reason # 2 - Determines when newly created financial instruments should be regulated under securities laws: Consider LLCs, which are hybrids of partnerships and corporations, where it is unclear whether should be treated as security, so we will look to passivity of investors and access to information

c. Reason #3 – Contract and bankruptcy law does not provide enough protection: Classify as securities because (1) deterrence (greater penalties, and no common law of fraud); (2) ex ante rules promote certainty and regularity; (3) collective action problem where not have ability to force disclosure that is necessary if leave it only to contract law (collective action problem as most correct, problem that FSL trying to address)

d. Reason #4 – To determine compliance with ’33 and ’34 Act: If determine that security, must have registration and disclosure (S5), liability will attach for sale of unregistered securities and misrepresentation in public offerings (S12a ’33 Act), registration/disclosure for companies with publicly traded securities (’34 Act), antifraud liability, including nationwide service of process

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(10b5), limits on insider trading (16b of ’34 Act), registration and regulation of intermediaries (’34 Act)

H. Five Themes to Consider About the “what is a security” case law: a. Theme #1 - Offerees/availability of market (trading/investment market) : More people

offered to, more likely to be security, and if there is a market for distribution, more likely to be security (Forman/Landreth, speaking about negotiability)

b. Theme #2 - Existence of risk : To the extent that transaction creates investment risk to offeree, more likely to be security (if factors that mitigate risk, eg, alternative regulatory regimes such as ERISA, federal banking laws, this weighs into finding against something being a security)

c. Theme #3 – Investor Expectations : If reasonable expectation that covered by securities laws, then more likely that will be a security

d. Theme #4 – Investors Motivations : If the investors are seeking to make a profit, and not invest simply based on consumption, then more likely will be as security

e. Theme #5 - Economic Realities of the investment : Court will note consider a label dispositive and look through the form of transaction to determine the economic realities and if it is consistent with features of a security as per Howey, Landreth, and Forman, then the label placed on the transaction doesn’t really matter

i. CONCLUSION: All the courts care about is INVESTOR PROTECTION

Chapter 4: The Public Offering

A. Overview of the IPO Process and Initial Public Offerings Generally, pp. 135-43 a. 14 Step Process in IPO

i. #1 – Company + Managing UW: no binding agreement, just letter of intent (indicates managing UWs willingness to organize the offering)

ii. #2 – Drafting RS and agreement among UWs: Counsel for company begins drafting RS, three agreements related to UWing (agreement setting up the syndicate; agreement w/ UWs and issuer about the amount + price of securities, AND agreement b/w UWs and dealers relating to sale of securities at discount from IPO price)

iii. #3 – Housekeeping work for company counsel: May need to have proper corporate structure and governance in place to conduct IPO

iv. #4 – Putting together syndicate: Managing UW puts together UW syndicate (informal agreement initially)

v. #5 – Filing RS: When company and UWs counsel happy with RS, this gets filed with SEC

vi. #6 – Continue to form syndicate and form dealer group: Managing UW continues to form UW syndicate and puts together preliminary dealer group

vii. #7 – Solicit interest for securities: UWs and dealers send preliminary prospectus to customers and make phone calls to create interest in the offering

viii. #8 – amending RS: Company will amend RS in preparation for effectiveness, may need amendment depending on material events that have occurred since the initial filing of the RS

ix. #9 – RS Ready, Issuer and UW finalize agreements: Once RS ready to go, managing UW and issuer will make final decision as to the terms of the offering (day before filing, then file the next morning to become effective)

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x. #10 –RS effective + price amendment: Company files price amendment to RS on morning of effectiveness to give final info on price to UWs, price to public, discount to dealers, and names of UWs involved.

xi. #11 – RS becomes effective: After amendments, RS becomes effectivexii. #12 – Sales begin: UWs and dealers, after signing dealer agreements, will begin

making sales to the publicxiii. #13 – Closing: Closing occurs in which $$ and securities change hands 3 business

days after effectivenessxiv. #14 – Closing the books: Managing UW closes books on the offering and distributes

profits to UWs or calls them to pay their share of the lossesb. Lead Underwriter & Selling Group (allotment)

i. Process : (1) Gets firms together to sell, (2) Allocates securities to members in group, (3) Establishes offering price shortly before sale through “bookbuilding” (v. bought deals, which are done quickly), (4) Performs price maintenance after sale, (5) Purchases by underwriter, (6) Anti-flipping clauses, (7) Insider lock-ups

c. Underwriting basic structure: i. Process: Will either have firm commitment, best efforts, or standby underwriting

from securities firms participating in the public offeringd. Agreement among the Underwriters :

i. Process : (1) Notice to underwriters: number of shares, time at which attorney power can be revoked, compensation, and (2) Allotment of shares to each underwriter (Important for (a) compensation, (b) liability limitation (by # of shares); (3) The “shoe” = Overallotments (important because (a) Sometimes there are more shares than anticipated, the option to purchase more shares is “green shoe” option, (b) stabilizing = manager buys back some shares in aftermarket ,limited by NASD); and (4) Anti-flipping Clause: Penalty for members whose shares flip, limited to the commission and may be as high as 150% of the commission).

e. Agreement between Underwriters and Issuer: This agreement will have (1) Price to be paid, (2) Identification of syndicate members, and (3) Clause mandating disclosure to security holders

i. Clauses that include 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 (fallback if cannot get indemnification clause inserted in the agreement with the UW and issuer)

5. Comfort Letter : From issuer to underwriter certifying truthfulness of information = way for underwriters to get out of liability (fraud, etc.) seek certain representation from the issuer

f. General Documentation Associated with an IPO (chronological order): i. (1) Letter of intent : Nonbinding agreement with issuer and UW that evidences UW’s

willingness to go through work to do IPOii. (2) Restructuring of companies : Look at mgmt, control, might need to reincorporate

elsewhere; need to be in certain corporate form in order to have an IPO (think BODs, implement review internal controls, corporate governance, comply with auditing and GAAPs)

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iii. (3) Drafting of registration statement and prospectus : Describe offering and the issuer, comply with extensive SEC disclosure requirements, Regulation S-K and S-X; Registration statement: file with SEC; Prospectus: selling document

iv. (4) Comfort Letters : issuer counsel must validate the incorporated, validly authorized, no deficiencies not reflected on balance sheet, must give opinion letter to issuer that complied with applicable corporate laws and must file with the SEC (protection against S11 liability)

v. (5)Agreement amongst underwriters : States that managing UW can act on behalf of syndicate, specify UW compensation, agreements about sale

vi. (6) Underwriters Agreement : B/w managing UW and the issuer; MAC conditions under which UW would be excused, obligates issuer to indemnify UWs for disclosure violations; specifies the price to be purchased and what can sell them for at the offering; May include the green shoe (allow UW to buy add’l share which under NASD amount to up to 15% of the original offering to stabilize the market price)

vii. (7) Selling agreements : B/w UWs and retail firms; require all sales to be at the same offering price (no antitrust violation, implied immunity for UWs and securities sellers b/c pervasively regulated by SEC)

g. Pricing concerns with IPOs: i. 2 types of transactions where will have to set stock price:

1. Issuing more stock : If have market price, already have benchmark. issuer and UW can set the price at a price somewhat lower than the prevailing market price with some degree of confidence that will sell

2. IPO : If no market, question about price setting more complicated. UW needs more analysis to determine the right price for the security and valuation for the IPO (i.e., present discounted value) since want assurance that will be able to sell all the stock

ii. IPO Pricing Controversy : Studies that show IPO tends to generate significant trading gains on the 1st day of trading (is the issuer getting full value if shares trade at 20% premium on the first day ,were they appropriately priced to begin with)

1. BUT CONSIDER : IPOs underperform the market over time (spike then slowly trend down and performance relative to peer group tends to be disappointing raising ? of why/efficiency of market and why offers spike on the first couple days of trading

a. Why would underwriter underprice the IPO : They assume the risk, price lower to make sure all the shares sell, want to get the deal done, BUT sets prices lower than needs to get deal done

h. IPOs are Underpriced in the short-term, then pop :i. Why large jump in prices of stock during IPO: (1) Companies need capital right

away, the jump in price is a risk premium for the underwriter who takes on the securities to sell them; (2) Strategy for bolstering public image of the company to see the stock price jump studies show that good purchase in short term and bad in the long term for IPOs

1. Policy issues: (1) Underprice b/c want to ensure that all sell, (2) Method of insurance against S11 misstatement since rarely sue over good buy, (3) Problems with the relationships b/w analysts and UW groups that work for the same investment banking firms

a. See Regulation A-C : Requires that analysts certify that their recommendations, including those made in public appearances, accurately reflect their personal views regarding the issuer’s

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performance and prospects and must disclose whether the analysts’ compensation is dependent on the views expressed about the issuer

b. See Section 151 of ’34 Act: Calls for structural safeguards to make sure that analysts are independent from the investment banking activities of the firm and protects analysts from retaliation against unpopular recommendations (but still nothing on Spinning practices)

ii. Ethical concerns with large stock jumps in IPOs : (1) Underwriter gives issues at lower than necessary prices (allows seller to profit off of margin, get business from them in the future); (2) Issuer underprices the issue to give value to the underwriter

1. Bad/Illegal with IPOs : underpricing the issue for favors to come back to management; form of kickback, first buyers in the IPO selling on the 1st day are called “flippers” if buy and sell immediately

a. Spinning : IB spins hot issue to flippers who ten buy and sell on the 1st day, led to enforcement actions by SEC (flippers usually corporate executives

b. Laddering : IB’s as UWs use their ability to allocate hot issues to extract from customers agreements to purchase add’l shares in aftermarket after IPO issued to maintain the price of the shares laddering subject of SEC enforcement activity and been dealt with through global settlements

2. Acceptable : underpricing the issue for favors to come back to issuer/companyiii. Method for reforming pricing – Dutch Auction: Solicit offers for # and price of

shares; and then count down from the top by number of shares you have available. You draw the line there, and offer it to everyone at that lowest price (see Google IPO)

1. Why Dutch Auction and how impacted Google : (1) Boost after IPO is good for their image; (2) Protection against liability because it decreases likelihood of a drop

2. Benefits flow to issuer rather than UW: DA does not eliminate pricing problem, core difference that more $$ captured by issuer with DA than with the firm commitment where UWs and initial investors capture the pot on the first day

iv. What is better way to price issues: (1) As in Treasury bill market, securities would trade before issued this would allow issuer to price offering “at market”; (2) SEC effectively prohibits through restrictions on short sales and unregistered securities; (3) Concern about trading unregistered securities could be alleviated by limiting this to institutional investors who can fend for themselves

B. Underwriting, pp. 115-35 a. What is underwriting?: Function of helping a company or one or more of its major

shareholders sell securities to the public through an offering registered under the Securities Act (’33 Act). Issuer (originator of securities) arranges with financial firms (intermediaries) for the distribution of securities to public investors.

b. 3 different types of underwriting: Firm may engage in 1 of 3 types of underwritingi. “Firm Commitment” Underwriting: Syndicate of UW’s purchases securities from

issuer to sell to public at agreed upon offering price 1. What is the underwriting syndicate: Group of UWs that will participate in IPO

based on an agreement with issuer and between underwriters2. What is the “gross spread”: Difference between issuer price and public

offering price (3 parts)

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a. Usually 7% (UW’s receive about 30% of the spread; Selling concessions of about 70% of the spread)

3. Risk in “firm commitment” : Competitive process because UWs share risk in firm commitment (slow sale and inability to sell tie up capital, affect reputations)

ii. “Best Efforts” Underwriting : Broker-dealers agree for fee to use best efforts to sell securities at agreed price to the public. UWs may agree to sell whatever portion they can or can be “all or none” basis, or an “agreed-minimum percentage” basis

1. Types of BE UW :a. Straight” = any securities sold closes deal (no min. amt that must be

sold as a condition to the deal closing)b. “Mini/maxi” = specific minimum amount of all the shares must be sold

during a specific time period for deal to close (proceeds in escrow until # is hit of shares sold)

c. “All or none” = all must be sold before a deal can closed. EA Rule 15c2-4: not allowed to close out an offering before satisfying

stated conditions (might have temptation to close out and “fudge” but expose self to liability if do this)

2. Risk in “BE” : BE used most often by smaller UW’s unwilling to risk buying the offered securities

iii. Standby Underwriting or “rights offering” : issuer directly offers the securities to the public and the UW (acting as an insurer) agrees to purchase from the issuer any securities not purchased by the public. UW paid fee for assuming risk of the insurer.

1. When typically used : When companies gives existing shareholders the right to purchase additional shares

iv. Alternatives approach – the Dutch Auction : Investors bid for the number of shares they want at the price they are willing to pay, and when the bidding ends, the issuer sets the price at the lowest bid that clears that offering, and the winning bidders buy the number of shares they wanted at the clearing price, and the bidders at the clearing price divide the remainder.

C. The Registration Statement and Section 5 of the ’33 Act, pp. 143-47 a. Role of Section 5 of the ’33 Act : S5 ensures that investors receive material information when

they sell securities in a public market. Mandatory registration system with heightened liability provides this protection and compels the creation of 2 documents by an issuer of securities in a public offering

i. S5 Compels creation of 2 documents in connection with public offering: 1. Registration statement (Not necessarily disseminated, filed document, public

record)2. Prospectus (Broad distribution of prospectus, NOT registration statement)

b. Importance of RS under ’33 Act : Under the 1993 Act, before securities can be offered and sold to the public, the issuer must file a RS with the SEC and provide investors with a detailed prospectus

i. Contrast with registration requirements under ’34 Act : 1. ’34 Act calls for registration of any class of publicly traded equity securities and

operates to register public companies2. ’33 Act registration only covers a particular offering of securities

ii. Personalities of RS (1) Must pass SEC muster and disclose information required by relevant form; (2) Prospectus as selling document; (3) Written with an eye toward litigation

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c.d. Pros and Cons of Registration or being publicly held : There are many advantages to

registering a certain offering of securities or being a publicly held companyi. Pros of Registration: (1) Cashing in: allows entrepreneurs who initially invested to

make return on their investment in the company; (2) Economy: may be the most economical way to raise large amounts of money in a short time; (3) Control: Avoid giving up some degree of control, as would have to in a private placement; (4) Creation of liquidity: registering and selling newly issued stock will provide owners of the company with liquidity, which can help raise new capital; (5) Prestige: certain status attached to being major shareholder, director, or officer of public company; (6) Executive recruiting and retention: Give executives stock as liquid compensation and can do so by just taking on additional public shareholders; (7) Acquisitions: When stock desirable, company can acquire other companies using stock, rather than cash, as consideration for the deal

ii. Cons of Registration: (1) Expense: direct and indirect expenses, including legal fees, audits, compensation of securities firms, and filing fees, and in addition ongoing disclosures and compliance in annual reports that must be given to stockholders; (2) Disclosure of information: Great deal of information must become public in ’33 Act RS and periodic disclosure under the ’34 Act; (3) Freedom of Action: Decision making process modified once public, as imposes fiduciary obligations to the shareholders by D&O’s, greater formality and less flexibility in decision making process for managers; (4) Income expectations: Unlike private company, where goal is to minimize income so as to minimize income tax, public companies shareholders care about current earnings and boosts in stock prices so they can sell at profit

e. Important Statutory Section of ’33 Act Dealing with RS: i. 2a8 – Definition of RS: Provides that effective 20 days after filing, issuers can file

delaying amendment, and SEC can accelerate effective dateii. 5a – Prohibition on sale of unregistered securities: It is unlawful to sell unregistered

securities in interstate commerceiii. 7 – Requirements of RS: “Shall contain the information, and be accompanied by the

documents specified in Schedule A”, SEC can delete/increase information in Schedule A

iv. 10 – SEC regulates PR: SEC regulates contents of prospectus under S10f. Information required in the RS

i. Process to determine what must be in RS: 1. Step #1 - Determine what form must be filed with the SEC

a. Form S-3 : reporting company for 1 year under ’34 Act, public float of at least $75 million if off6ering new equity securities, or if offering investment grade debt no float requirement

i. Can incorporate by reference from other SEC filings and only describe the particular offering (based on ECMH, market price reflects material info about the offeror so an investor can assess the economic attractiveness of the offer by reference to the current market price)

b. Form S-1: residual form, nonreporting issuers (always in IPOs) and unseasoned reporting issuers (issuers with reporting obligations under 1934 Act but not for S-3 requirements)

2. Step #2 – Consult Regulation S-K to determine what must be disclosed :

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a. Depending on whether file S-1 or S-3, Regulation S-K will provide detailed guidelines for what must be specifically disclosed with relation to each specific form

ii. 4 categories of information must be included in RS: 1. Category #1 - Information with respect to registrant:

a. General info: (1) Detailed description of registrant’s business, property, and mgmt (D&O’s); (2) Any legal proceedings; (3) High and low stock prices within the last two fiscal years, # of holders, and frequency/amount of dividends for each class of stock.

b. Summary : Issuer required by 501c of Regulation S-K to set forth terms of offering and page with risk factors in the summary

c. Risk factors : 503c, require that include specific factors that make speculative or high risk, and risk factor section must be in plain English (Rule 421d, short sentences, everyday language, active voice, tabular presentation of complex material, no legal jargon, and no multiple negatives)

d. Financial statement requirements : Regulation S-X for financial statement requirements, must include audited balance sheets for 2 preceding fiscal years; audited income statements and statements of changes in financial position for each of the three fiscal years preceding the date of most audited balance sheet

i. Items 301 and 302 of S-K : require disclosure of other financial info that supplements and emphasizes the information in audited financial statement

ii. Item 303 : ID trends and developments that have reason to believe will affect the registrant

2. Category #2 - Information about the distribution and the use of its proceeds a. General info : (1) UWs in privy with registrant must disclose general

terms of their agreement and their compensation (both aggregate and per share basis); (2) Net expected proceeds and if plans for proceeds with registrant

3. Category #3 - Description of the securities of the registrant: a. General info : (1) Rights, privileges and preferences of security being

offered; (2) Any provision that would subordinate the holder’s rights to other security holders; (3) Any provision that would restrict the registrant’s ability to incur the indebtedness or the payments of dividends; (4) When offering price for an equity security is substantially different from that which insiders purchased it for in the past 5 years, the registrant must highlight that information (unless reporting company prior to filing RS)

4. Category #4 - Exhibits and undertakings :a. General info: (1) Must file articles of incorporation, bylaws, attorney’s

opinion of the legality of securities being registered, (2) Any 10-K or 10-Q reports incorporated by reference into registration statement; (3) Any undertakings imposed on the registrant; (4) Info regarding all unregistered securities sold during the last 3 years

g. Categories/Types of Issuers Subject to ’33 Act (Defined in Rule 405) i. Type #1 - Well-Known Seasoned Issuers (WKSIs)

1. Form use for RS : Eligible to use Form S3

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2. Characteristics of WKSI : (1) Any issuers with a common stock market capitalization (excl. shares held by affiliates) of $700 million; or (2) In the case of non-convertible preferred stock offering, issuers who in the prior 3 years have offered $1 billion in non-convertible securities & have a common stock float of $75M

ii. Type #2 - Seasoned Issuers: Large, Reporting Companies 1. Form : Not WKSIs but can use the S-32. Characteristics: (1) 12 months of timely Exchange Act Reports; (2) Must report

for over 500 shareholders, whether or not listed on an exchange; (3) Large size: $75 million + in common stock public float (see Rule 405 for definition of “smaller reporting company” under $75 million) OR offering investment grade nonconvertible debt

iii. Type #3 - Unseasoned Issuers 1. Form : Fail to meet the eligibility requirements of Form S-3, must use S-12. Characteristics : IPOs fall into this category; these are issuers that are required

to file reports under the Exchange Act, or are voluntarily doing so, but do not qualified as seasoned issuers

a. When required to report under Exchange Act (and potentially considered unseasoned issuer): (1) Class of securities listed on national exchange, (2) Excess of $100,000 in assets and c lass of equity securities in the hands of at least 500 holders, (c) Registered securities under ’33 Act w/in last year, or (d) Registered securities under ’33 Act that are in the hands of at least 300 holders

iv. Type #4 - Non-reporting issuers 1. Form : Not required to file exchange act reports2. Characteristics : Shell or penny companies; or bad actors (violators of SEC

rules)v. Hierarchy among types of companies (WKSI non-reporting issuers) :

1. WKSIs : Least demanding of WKSIs w/r/t reportinga. Rationale : Been around, lot of information out there; more reason to

believe market is efficient with respect to the issuer2. Moving down the scale from WKSI : Companies have less info out there, more

skeptical of whether the market informed enough to be efficient w/r/t those companies (more demanding in terms of disclosure)

a. More information = more information considered in the market = more relaxed compliance becomes

D. Unseasoned Issuers, pp. 147-58 a. Registration of the unseasoned issuer : Effort and expense of an IPO are far greater than for an

offering by a company that is already publicly tradedb. Role of Section 5 of the ’33 Act: Restrictions on the freedom of the issuer and underwriters to

promote the offering until the registration statement is filedi. Period leading up to filing of RS for issuer/UW is quiet time but not serene

ii. Once RS filed, UW’s can sample investor interest by aggressively soliciting offers to buy

iii. Bars any sales until RS becomes effective; when RS being reviewed by SEC, significant efforts underway to promote the offering

c. Preparation of RS for Filing :i. Role of registrant’s atty : Burden of assuring registration statement is prepared in

accordance with the SEC regulations falls to registrant’s attorney, must also take

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care of (1) reorganization of corporation, recapitalization, determine proportion of stock sold to public and (2) Enter or terminate employment agreements, adopt stock option plans, transfer RE, revise leases, rewrite corporate charter and by-laws, agreements w/ shareholders

ii. Timeline : 2-3 months before RS can be filed, SEC issue letter of comment w/in 30 days

d. SEC Review :i. 8a : RS can, barring other action, become effective 20 days after filing BUT

unseasoned issuers/other problem companies can expect much longer wait than 20 days before RS can become effective

1. Delaying amendment postpones the automatic effective date of RS until the issuer has amended the RS to comply with SEC comments

2. Acceleration: if amend RS to comply with SEC comment, can set earlier than 20th day for effective date (see Section 8a/8c)

e. Other relevant rules i. Pricing amendment and Rule 430A : allows RS covering an offering of securities for

cash to become effective w/o price related information, provided such info is made available by a supplement to the prospectus w/in 15 days of effective date

ii. Acceleration requests :1. Rule 460 : Depends on whether sufficient circulation of preliminary prospectus

among underwriters and dealers and also on adequacy of information in prelim prospectus

2. Rule 461 : Conditions acceleration on, inter alia, prospectus being “reasonably concise and readable”

iii. Indemnification : Section 11 imposes liability on certain persons if RS contains a material misrepresentation when becomes effective (certain D&O’s)

1. 512i : If claim for IND made for D&O or controlling person, registrant will submit the propriety of such indemnification for approval by court unless counsel opines that propriety of indemnification is settled by controlled precedent

iv. Small business issuer system : Simplified reporting for (1) Issuers who did not exceed $25 million securities, (2) issuers whose public float does not exceed $75 million certain scaled disclosures only apply to smaller issuers

v. Other registration forms 1. Form S-4 : securities in business combinations2. Form S-8 : securities offered through employee stock purchase and savings

plan3. Forms F-1 through F-6 : foreign issuers4. Forms S-1 or S-3 : asset backed securities, disclosures guided by Regulation AB

vi. Blank check offerings : Special protective requirements under Rule 419 for blank check companies who lack any specific business plan or purpose and whose purpose it is to engage in acquisition of an unidentified company

E. Section 5 of the Securities Act – The Heart of the Securities Act a. Three relevant Periods Under Section 5:

i. Prefiling period (5a and 5c): Offering and sale of any security is prohibitedii. Waiting period (5a, 5b1): After RS is filed with the SEC but before it becomes

effective, sales are prohibited and written offers are strictly regulated

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iii. Posteffective Period (5b): After RS becomes effective, written offers continue to be regulated and all purchasers must receive a prospectus whose contents comply with the statutory and SEC specifications

b. Relevant Statutory Provisions of Section 5 of the ’33 Act: i. Section 5(a) : No sales or deliveries of registered securities before the registration

statement is effective1. Period when 5a applies : Prefiling period, waiting period

ii. Section 5(b)(1) : After RS filed, requires that all written offers to sell be in connection with a prospectus that complies with Section 10 of the ‘33 Act

1. Period when 5b1 applies : Waiting period, post-effective period2. Purpose: wide distribution of prospectus such that investors have reliable

informationiii. Section 5(b)(2) : A final prospectus must accompany any transportation of the

securities to investors1. Period when 5b2 applies : Post-effective period2. Jurisdictional hook : Use of any means or instruments in transport in

“interstate commerce or the mails”. Does not apply to face to face communication BUT if $$ mailed after F2F negotiations, then j/d requirements met

iv. Section 5(c): No offers to buy or sell during the pre-filing period (prior to the filing of the RS)

1. Period when 5c applies: Pre-filing period2. Policy of Section 5 : balance to protect investors and at the same time

accommodating commercial considerationsc. Important Definitions Useful to Section 5 of the ’33 Act:

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. Jurisdiction of §5: Covers interstate commerce or the mails (at any point in entire deal)i. Securities Act § 2(a)(7) : The term "interstate commerce" means trade or commerce

in securities or any transportation or communication relating thereto among the several States or between the District of Columbia or any Territory of the United States and any State or other Territory, or between any foreign country and any State, Territory, or the District of Columbia, or within the District of Columbia.

1. NOTE : Face-to-face transactions are not subject to Section 5 restrictionse. Section 4 Exemptions from §5:

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i. Sections 4(1)-(2) : The provisions of §5 shall not apply to: (1) transactions by any person other than an issuer, underwriter, or dealer, or (2) transactions by an issuer not involving any public offering.

ii. Section 4(3) : Required even non-participating dealers to deliver a prospectus with the sale of securities, when they solicited the sale

1. NOTE : Applies for 40 days after the effective date (90 days for an IPO)2. BUT : Rules 153, 172, & 174 substantially lift this requirement for dealers

iii. Section 4(4) : Broker who does not solicit client’s interest is merely the client’s agent & is exempt from 5(b)(1) & 5(b)(2) (although it seems unnecessary for 5(b)(1) but is necessary for 5(b)(2))

1. Broker vs. dealer : Dealer solicits investor’s interest in the security, and absent solicitation, broker’s transaction exemption of section 4(4) applies, provided the broker isn’t acting as an underwriter

f. Liability for Violations of §5 i. Section 12(a)(1) : Any person who sells a security in violation of Section 5 is liable to

the person purchasing such security.g. Determining When the Registration Becomes Effective

i. §8 of ’33 Act : 20 days after filing ii. Rule 437 : Delaying amendment; everyone uses them

iii. Rule 461 : Request for acceleration of effectiveness (so it becomes effective upon review

1. Rule 461(b) : SEC can deny request on several grounds: prospectus not in plain English, preliminary prospectus inadequate or inaccurate, issuer under current investigation, an underwriter fails to meet financial responsibility requirements, an interested party has taken part in transactions manipulating market price, underwriter compensation hasn’t been cleared by the NASD.

F. Gunjumping, pp. 158-59 a. Pre-Filing Period, pp. 160-68, Problems 4-1 to 4-11:

i. What statutory section we care about in prefiling period: 1. Section 5a : No sales or deliveries of registered securities before the

registration statement is effective 2. Section 5c : No offers to buy or sell during the pre-filing period (prior to the

filing of the RS) (“shall be unlawful for any person . . . to offer to sell or offer to buy . . . any security . . . unless a registration statement has been filed to such security”)

a. Practical Impact of 5a +5c during PFP: No offers, no salesii. Main issue during the prefiling period: What constitutes an offer within the

meaning of Section 5c (typically 5a interpretations more of a problem during the waiting period, as opposed to the prefiling period)

1. Definition of an offer – 2a3 : Section 2a3’s definition of offer to sell, offer for sale, and offer, includes “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value”

a. NOTE: 2a3 is nonexclusive list so possibly even bigger than this. i. Presumably means to have common law definition and then

push outward, as SEC has read the definition of “offer” broadly to including prefiling activities that , while falling short of common law offers, condition the market for the securities to be sold

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b. What we care about with an offer: Has there been prefiling activity that “conditions the market” for the securities seeking to be sold?

iii. Conditioning the Market for Securities During the Prefiling Period 1. When does “conditioning the market” occur : Occurs “while in registration.”

The process of registration runs at least form the time the issuer reaches an understanding with the dealer-broker which is to act as managing UW, until completion of the offering and period of 40-90 days during which dealers must deliver prospectus.

2. Securities Act Release 3844 and Conditioning the Market : Any communication that conditions the market or arouses public interest is considered solicitation of an offer to buy

a. “Publication of information and statements, and publicity efforts generally, made in advance of a proposed financing, although not couched in terms of an express offer, may in fact contribute to conditioning the public mind or arousing public interest in the issuer or in the securities of an issuer in a manner which raises a serious question whether the publicity if not in fact part of the selling effort (No. 3844)

3. Example of Conditioning the Market - In re Carl M. Loeb, Rhoades & Co. : Press releases that released before RS filed stated “conditioned the market” and violated 5c when press releases described property involved for RE development company, related the development plans in general terms, outlined proposed securities offering, and mentioned named of 2 managing UWs

a. Rationale: These releases “were of a character and calculated, by arousing and stimulating investor and dealer interest in the securities . . . to set in motion the process of a distribution”

iv. Permitted activities during the prefiling period – “SAFE HARBORS”: 1. Why do we need safe harbors: Problems with legitimate commercial needs to

release information and command of 5c not to condition the market 2. What is permitted during the prefiling period?

a. Exempt Persons – 4(1): Prohibitions on conditioning the market do not apply to anyone other than issuers, UWs, and dealers

b. Preliminary negotiations are ok: 2a3 exempts from definition of “offer” preliminary negotiations or agreements between the issuer and UWs, or among UWs, that will be in privity with the issuer (i.e., if the parties are or will become parties to the UW agreement with the issuer)

i. NOTE: Participants who don’t absorb any of the offerings risk are excluded

c. Securities firm recommendations and “research reports”: i. (1) Nonparticipant recommendations permitted – Rule 137 :

Securities firm not participating in the distribution may recommend securities of an issuer in registration if in the regular course of firm’s business, issuer is reporting company, and securities firm has received no special compensation (see Rule 137, exemption from definition of UW)

1. Anything goes with nonparticipants: Can publish anything they want since not getting paid. Allows nonparticipating brokers and dealers to publish or

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distribute, in the regular course of business, information, opinions, and recommendations regarding securities of an issuer in registration

ii. (2) Recommendations of the issuer’s non-offered securities – Rule 138: Any securities firm may (incl. one involved in the distribution) recommend as part of its regular business, the issuer’s common stock if the offering is for preferred or nonconvertible debt securities (see Rule 138, exemption from definition of an offer). Converse also true (can recommend preferred or debt securities if offering is for common stock). Only applies to recommendations for certain seasoned reporting companies that file Form S-2 or S-3.

1. Different kinds of securities: Participants/non-participants can publish about different kinds of the issuer’s securities not included in the offering

iii. (3) Participant Recommendations – Rule 139: Securities firm participates in the distribution may recommend buying issuer’s securities if the recommendation appears in a regular publication and either (a) the issuer is large, seasoned reporting company that meets requirements for Form s-2 or S-3, or (b) company is a reporting company and recommendation included in report that includes other securities, receives no special prominence, and is no more favorable than last recommendation sent out before firm became participant in the distribution (see Rule 139, exemption from definition of an “offer”)

1. Can’t use it for IPOs: Rule cannot be used to escape liability for an IPO

2. 139(a)(1) Focused reports permitted : (1) Broker or dealer, whether or not a participant in the distribution, may issue reports focused on the issuer provided the issuer meets requirements of Forms S-3 or F-3 and is not a bad actor. (2) Broker/dealer must have previously distributed a report in the regular course of business. (3) New report can’t be a re-initiation reporting on issuer

3. 139(a)(2)Industry reports : (1) Broker/dealer can issue reports about the issuer’s industry; must be in the regular course of business. (2) Issuer must be a reporting company & not a bad actor. (3) Must contain info about other issuers in industry or be comprehensive list of securities currently recommended. (4) Issuer’s securities can’t be given any particular prominence

a. NOTE - NASD Rule 2711: Restriction on Managing Underwriter for 40 Days: Bars the managing UW from issuing investment report about offering until 40 days after

d. Company announcements :

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i. Intention to make public offering – Rule 135 : Issuer can announce its intention to make a public offering by stating that (1) the amount and type of the security to be offered, and (2) the manner and purpose of the offering. The announcement must state that offering made by prospectus but CANNOT identify the UWs or the expected offering price (see Rule 135, only way offering can be publicized during prefiling period, see CA2)

1. Operations and activities : It’s not an offer if the issuer releases information about its operations and activities, even though the issuer is in registration

2. Legend requirement: Need a legend stating it is not an offer

3. No UWs or Offering Price : Cannot identify prospective underwriters or offering price in a pre-filing release

ii. 30-day Safe Harbor (bright line exclusion) – 163A: Any communication made by or on behalf of an issuer (other distribution participants not protected) more than 30 days prior to the filing of the RS will not be deemed an offer if that communication does not refer to the offering of securities. Issuer must take reasonable steps to control further distribution/publication of the communication w/in 30 days before filing the RS (Rule 163A)

iii. Factual Business Information – Different Standards for Reporting and Nonreporting Companues:

1. Nonreporting issuers – 169 : Nonreporting issuers can continue to communicate factual business information regularly released to persons other than in their capacity as investors or potential investors (see Rule 169)

a. Similar to Rule 168, BUT: i. Only applies to factual information

that is not forward-lookingii. Intended audience must not be

investors, but others such as customers and suppliers. Consider whether you’re advertising in an industry magazine or an investment magazine.

2. Reporting issuers – 168 : Reporting issuers under ’34 Act can communicate regularly released factual business information and forward-looking information and it will not be treated as an offer to sell the security, nonwithstanding the type of recipient (see Rule 168).

a. Issuer : Only applies to comm. by or on behalf of the issuer (doesn’t apply to UW)

b. Ordinary course of business : Must be the type of information that the issuer previously released in the ordinary course of business

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c. Manner of dissemination : Manner of dissemination must be similar to past releases of similar type of information

d. Nothing about registered offering: Excluded from the safe harbor is any communication about the registered offering (except allowed under 134 & 135)

iv. WKSIs and Offers via Free Writing Prospectus - 163 : WKSIs may make unrestricted oral or written offers at any time via a free writing prospectus, as long as the offers bear certain legends, be retained for 3 years, and filed with the SEC (free writing prospectus, see Rule 163)

1. Issuer : Must be by or on behalf of the issuer; this doesn’t apply to underwriters

2. Disclosure : Written offer made prior to filing date must be filed “promptly” with the SEC under Rule 163(b)(2) when RS ultimately filed and must bear the legend required in Rule 163(b)(1)

3. Failure to include legend - Rule 163(b)(1)(iii) : Excuses “immaterial or unintentional” failure to include the specified legend, as long as there’s a good faith and reasonable effort to comply

4. Failure to file with the SEC - Rule 163(b)(2)(iii) : Excuses “immaterial or unintentional” failure to file the communication with the SEC, as long as there’s a good faith and reasonable effort to comply

v. Analysis to determine whether prohibited activity :1. (1) Was the communication by someone other than an issuer, underwriter, or

dealer?2. (2) Did it “condition the market”?3. (3) Was it made while the issuer was “in registration”?

b. Waiting Period, pp. 168-77, Problems 4-12 to 4-20 i. What statutory sections we care about during the waiting period:

1. 5a – prohibition on sales/delivers: Offers cannot be accepted during the waiting period since “sale” is any finalized contract. Solicitations of interest are ok, usual practice is for participants in an offering to collect indications of interest from investors but not take checks or otherwise accept orders.

2. 5c – Prohibition on Offers No Longer Applies : Section 5(c) no longer applies during the waiting period, and offers to buy/sell may be made.

3. 5b1 – no prospectuses unless comply with Section 10: During the waiting period, no offer, in writing or by radio/television, may be made except by a section 10 prospectus.

4. 2a10 – statutory definition of a prospectus: Defines prospectus as any communication “written or by radio or television, which offers any security for sale.”

5. Section 10 – Information Required in the Prospectus: 10a provides that a prospectus “shall contain the information contained in the registration statement,” with some exceptions. SEC adopts Rule under Section 10(b) to

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determine what types of prospectuses are permitted to be used during the waiting period.

a. NOTE: Prospectus is drafted for inclusion in the RSii. Which are the most important statutes during the waiting period: Section 5(b)(1)

and 2(a)(10) significantly shape the waiting period.1. 5(b)(1): Any communication may be seen as a prospectus unless it falls under

an exemption; and any prospectus must be a complete one2. 2(a)(10): Defines a prospectus broadly as any written communication, as well

as radio/TV communication (not oral offers); oral offers okiii. What activities are permitted during the waiting period?:

1. Oral offers are permitted – 5b1: The 5b1 prohibition only applies to written offers, although oral offers are subject to the antifraud provisions. 5(b)(1) does not reach oral selling efforts, except radio or TV

a. Role of effective date: Important constraint in 5(a)(1) that the arrangement or understanding cannot constitute the sale of a security prior to the effective date.

2. Preliminary/Red Herring Prospectus ok – Rule 430: 10b authorizes the SEC to permit the use of an incomplete prospectus, and Rule 430 permits the use of a preliminary or “red herring” prospectus.

a. What PP/RH: Prospectus given out during the waiting period that contains the information on file as the registration statement. It contains a legend printed on the cover page that cautions that securities cannot yet be sold/not registered/no sales until RS effective.

b. Info contained in PP/RH: It contains the information contained in the final prospectus but omits the offering price and information on the underwriting (substantially same information that will be used in final prospectus under 10a). Investors have same disclosure document available to the SEC.

c. Distinguish final prospectus under 10a: PP/RH different than statutory/final prospectus called for by 10a and used in the posteffective period to confirm sales.

3. Summary Prospectus permitted – Rule 431 : Rarely used, can be used instead of preliminary prospectus. Conditioned on issuer having been a reporting company for 36 months.

4. Tombstone ads permitted – 2a10 : Exempts communication w/r/t a security if it states from whom a prospectus meeting Section 10 requirements may be obtained and does no more than identify the security, price, and state by whom (which uw’s) orders will be executed

a. NOTE: Not used much anymore; replaced by identifying statements allowed under Rule 134.

5. Identifying Statement permitted – Rule 134 : This rule expands the “tombstone ad exception”, as certain info deemed not to be 2a10 or free writing prospectus.

a. What can do under Rule 134: Can give specified written info about the issuer and the offering (more than in tombstone ad) IF you explain who is selling securities and where to obtain preliminary prospectus BUT do not need to give this information if (1) incl. only info in tombstone ad or (2) send accompanying preliminary prospectus, OR you can ask investors to indicate interest in the offering return car, if also send preliminary prospectus and explain there is no commitment

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i. Permissible Info – Rule 134a : Can incl. brief descriptions of: title of securities and amount being offered; type of business; price; intended use; underwriter’s name; marketing plans- dates & times of road shows

ii. Solicitations allowed – Rule 134d : Permits a written communication to be sent during the waiting period to any investor asking her to express interest by completing a card or form

1. Preliminary prospectus req. : Must be accompanied or preceded by a statutory or preliminary prospectus

2. No acceptance : Must warn investor that no offer to buy can be accepted until the effective date

3. No filing : Rule 134 information does not need to be filed with the SEC

4. Legend requirement : Must include a legend saying the registration statement has been filed but is not yet effective, and telling readers where they can obtain a copy of the prospectus

6. Free writing prospectus permitted – Rules 164 and 433 :a. Effect of the rules : Before adopted, free writing only allowed AFTER

effective date of RS. Make free writing possible during waiting period. If the rules’ conditions are satisfied, free writing prospectus will be deemed to be 10b prospectus.

b. Allowed to use FWP – Rule 164a : FWP as defined in Rule 405 of any offering participant, after filing the registration statement will be a 10(b) prospectus for purposes of §5(b)(1) provided that Rule 433 provisions are satisfied.

c. Definition of FWP – Rule 405 : Written communication that constitutes an offer to sell or solicitation of an offer to buy securities relating to a registered offering that is used after filing (or for a WKSI, regardless of filing) is made by means other than 10(a) prospectus or definition of prospectus in 2(a)(10).

d. Eligibility to use FWP depends on nature of the issuer: i. WKSIs can use FWP anytime – Rule 163 : FWP can be used by

WKSI at ANY TIME (Rule 163)ii. Seasoned Issuers can use after filing RS – Rule 433 : Rule 433

allows FWP use 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 can use FWP if accompanied by most recent prospectus - 433: Nonrep/unseason 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)

1. During the waiting period, this is a preliminary prospectus

2. For non-reporting and unseasoned issuers, it must include a price range

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3. Can be satisfied via a hyperlink, so UWs can engage in electronic free writing even for IPOs

e. Rule 433 Requirements for FWP :i. When and who must file copy with SEC : A free writing

prospectus generally must be filed with the SEC if: 1. (1) prepared or used by the issuer, if it includes

material non-public information provided by the issuer; or

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

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

b. FWP must be retained for three years ii. Contents of a Free Writing Prospectus: Purpose of FWP to get

people interested by providing them with knowledge about the final offer; but we want to make sure that they understand it is not the final offer.

1. Legend requirements - Rule 433(c)(2) : Any free writing prospectus must include a legend indicating where the prospectus is available from the underwriters through a toll-free number and advising investors that registration materials can be accessed through the SEC’s website

a. Rule 164 protection : Rule 164 provides a means to cure any unintentional or immaterial failure to include req. legend

2. Consistency requirement - Rule 433(c)(1) : FWP shall not contain info. inconsistent with info. in a filed prospectus, RS, or current reports

iv. Treatment of websites, road shows, and media during waiting period :1. Websites and issues that arise:

a. Possible that conditions the market : Is the information a prospectus because it conditions the market? If so, Section 5(b)(1) is violated because it contains more than just what is in the Section 10 prospectus.

b. Role of hyperlinks: Hyperlinks that connect a preliminary prospectus posted on a website with other information renders that information a part of the offering process.

i. Envelope theory : the question is whether the prospectus and other materials are in close proximity to one another such that they should be viewed as together

c. Historical information ok on website if in separate section - Rule 433(e)(2): Historical information about the issuer so identified and appearing in a separate section of the website is not considered to be part of an offering.

2. Road shows - Rule 405 and 433d8 : Road shows are regulated by Rule 405’s definition of “graphic communication” & Rule 433(d)(8)

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a. Real time exclusion - Rule 433(d)(8) : If it’s a transmission of a real-time presentation to a live audience, it’s not a prospectus.

i. If not real time, then GC and FWP : If the broadcast is not in real time and to a live audience, then it’s a graphic communication & counts as a free writing prospectus

ii. If not real time, must comply with conditions for FWP : If it’s a free writing prospectus, it must include specified legends & be filed with the SEC

iii. Only applies to equity security, non-reporting company, and if not publicly available: Rule 433(d)(8) only applies to an offering of an equity security, for a non-reporting company, and if the issuer has not made at least one version of the road show publicly available

3. Media Communication Prepared in exchange for payment – Rule 433 : If the issuer or someone acting on its behalf prepares, pays, or gives consideration for the preparation of media communication, it is treated as FWP and must satisfy all requirements of Rule 433 (to the extent that the information provided exceeds that permitted by Rule 134)

a. No payment, then just must file: If not, then filing requirements of the Rule are satisfied if a copy is filed with the SEC within 4 business days of the issuer becoming aware of the publication

v. Exchange Act Rule 15c2-8: Duty to Provide Preliminary Prospectus if Asked: Broker or dealer participant must deliver a copy of a preliminary prospectus 48 hrs prior to the mailing of a confirmation, if the issuer is not previously a reporting act company

1. Customer requests: If your customer asks, without solicitation, for a preliminary prospectus you have to make reasonable efforts to provide it to them

2. Acceleration: SEC won’t accelerate effective date of an issuer not subject to the Exchange Act’s reporting requirements unless copies of the preliminary prospectus have been or are being distributed to all persons whom the UWs expect to send a confirmation not less than 48 hours prior to the date the confirmation is expected to be mailed

3. UWs and dealers: Must take reasonable steps to furnish copies of preliminary prospectus to UWs and dealers’ salespeople.

vi. Prospectus dissemination during waiting period: Problem in that investor can get oral offer during waiting period, place and order contingent on RS becoming effective, and never receive S10 prospectus, as 5b1 allows, but does not require, a preliminary prospectus during the waiting period.

1. Result: SEC says must takes reasonable steps to ensure that preliminary prospectus been made available to all participating UWs and dealers (Rule 460, condition on acceleration). And Exchange Act 15c2-8 says that participating UWs/dealers must take reasonable steps to furnish PPs to salespeople and investors who request them, AND must send PP to any investor expected to receive confirmation of sale 48 before sent the confirmation of sale.

c. Post-Effective Period, pp. 177-82, Problems 4-21 to 4-26 i. What statutes we care about during posteffective period:

1. 5b1 – prohibition on prospectus unless comply with S10 : Prohibition on use of any prospectus, unless it complies with S10.

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a. NOTE: During waiting period, SEC under 10b said that can use preliminary prospectus (Rule 430), summary prospectuses (Rule 431) and FWP (Rule 433). NOW, once in post-effective period

i. (1) Can still use summary prospectus in certain circumstancesii. (2) FWP can be used, although for non-WKSIs/non-seasoned

issuers that use FWP, the FWP must be accompanied by (hyperlink ok) or preceded by final prospectus

2. 5b2 – prohibition on delivery unless 10a final prospectus : Prohibition on the delivery of securities unless accompanied/preceded by a 10a prospectus (final or statutory prospectus).

a. What included in final/statutory prospectus : All info in preliminary prospectus + offering price, UW compensation, amt of proceeds, and other info. dependent on the selling price

3. 5a1 - no longer prohibits sales: Prohibition on closing sales no longer exists once the RS becomes effective.

ii. Permitted activities during the posteffective period: 1. Prospectus delivery with confirmations – 2a10/10a: a confirmation of a sale is

not a prospectus if it is preceded or accompanied by a final, statutory 10a prospectus.

2. Prospectus delivery with securities delivery – 5b2/10a: 5b2 prohibits devliery or securities after a sale unless accompanied/preceded by 10a prospectus, so as long as 10a precedes/accompanies, than delivery of the security will be permitted in posteffective period.

3. Prospectus requirements satisfied if aggregation by use of term sheet – Rule 434 and “new term sheet” option: Participants in a firm commitment cash offering satisfy their prospectus delivery obligations by aggregating information that investors receive.

a. If send Preliminary Prospectus + Term Sheet w/ information not included in the preliminary prospectus = Sufficient for §10(a) Prospectus

i. Result : Firms can orally solicit orders, send preliminary prospectus during the waiting period, and after effectiveness mail a confirmation with the pricing term sheet to complete the sale.

4. Prospectus Access = Delivery – Rule 172: Access equals delivery under Rule 172.

a. Written confirmation - Rule 172(a) : Exempting from section 5(b)(1) written confirmations; brokers can confirm sale without having to physically provide a final prospectus; just need to provide notice of the sale (buyer is expected to be able to know how to find it online at the SEC)

i. BUT Exchange Act Rule 15c2-8(b): still requires UWs deliver PP to buyers 48 hours before sending confirmation of sale

b. Transfer of Registered Securities - Rule 172(b) : No need to deliver a prospectus with delivery of securities if: (1) Registration is effective & not subject to any action, and (2) Statutory prospectus meeting requirements of §10(a) has been or will be filed with the SEC in a timely manner

i. Because it’s already too late, just tells the buyer whether to sue or not

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c. Deliver requirements - Rule 172(c) :i. Issuer must have filed a prospectus satisfying 10(a) within the

time required under Rule 424ii. Rule 172(c)(4) says dealers are not required to deliver a

prospectus in connection with transporting the distributed security

d. Rules 172(c)(4) & 174(h) : Excuse delivery of a prospectus provided the issuer’s registration statement is not the focus of an enforcement proceeding

5. Use of FWP in posteffective period ok - Rule 433: FWP’s permissible if meet (1) legend requirements and (2) filing requirements BUT 10a permits FWP in POST EFFECTIVE Period only if FWP accompanied or preceded by FINAL prospectu

a. FWP: If after RS effective, can use FWP provided that accompanied by FPR

iii. Underwriter’s Prospectus Delivery Obligation for IPO : a. PP before confirmation : UWs must deliver prelim prospectus at least

48 hrs to before sending sale confirmation, Rule 15c2-8(b)b. No 10 prospectus: But no final prospectus delivery requirement (acces

= delivery) as a condition of mailing confirmation of salei. Notice of sale must occur within 2 business days of sale

c. Rule 173 - Notice of Registration : (no §5 liability for violating) : In a transaction involving a sale by an issuer or UW to purchaser; or a sale in which the final prospectus delivery requirements apply: (1) not later that 2 days after sale, (2) each UW or D will give a final prospectus to each purchaser, or (3) will give notice that such is not req’d due to Rule 172

i. NOTE : Investor can request a final prospectus.iv. Delivery of prospectus obligations : Must look to Section 4 to determine how long

participants in an offering must delivery a prospectus, whether to accompany confirmations or the delivery of securities

1. Who does prospectus delivery requirement apply to: burden ONLY for issuers, UWs and dealers

a. Issuer : Indefinitely, §4(1). Issuer subject to FWP requirements of Section 5 as long as offering the security to the public

b. UW or B/D Holding Original Allotment : Indefinitely, for sales from original allotment, §4(3)(C). Subject to FWP requirements as long as allotment/subscription in distribution remains unsold.

i. REMEMBER : Scope of FWP reduced in posteffective period as per 172a (written confirmation/notice of allocation no prospectus), 172c4 (dealers not required to deliver prospectus in connection w/ transporting distributed security), 173 (if no 4(3) or Rule 174 exemption, must give final prospectus not later than 2 days following completion of sale)

c. Resales by Dealers (ie. Securities Firms §2(a)(12)) : Depends on info avail on issuer, §4(3)(B)

i. 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 sentence

ii. 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)

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iii. 25 days , if the securities are listed on a stock exchange or NASDAQ, Rule 174(d)

iv. 0 days , if the issuer was a reporting company when it filed its RS, Rule 174(b)

v. 0 days , if the RS relates to offerings from a shelf and the relevant §4(3) period has already expired for the first time

vi. 0 days , if dealer does not solicit client’s interest, §4(4)vii. 0 days, if securities sold through an exchange, Rule 153

v. Updating and Correcting the Registration Statement in the Post-Effective Period : When circumstances change from what was filed in the prospectus, the issuer must amend or supplement the prospectus to make changes. If this is not done, there is a violation of §5(b)(2) because the prospectus on file no longer meets the requirements on §10(a)

1. Material though minor change requires sticker – Rule 424b(3)-(5): Can sticker the prospectus with the new information

2. Fundamental requires amendment: If event is fundamental and not material, the issuer must amend the RS and wait for SEC to declare RS effective

3. Stale information – 10a3 : If a prospectus used more than 9 months after ED, info in prospectus cannot be more than 16 months old. Thus, prospectus may have to be stickered if used more than 9 months after the RS becomes effective.

G. Seasoned Issuers, pp. 182-92, Problems 4-27 to 4-33 a. Integrated disclosure for the seasoned company:

i. Purpose of integrated disclosure : Eliminate duplication due to disparate ’33 and ’34 Act reqm’ts w/o compromising information needs of investors so that regulatory burdens on issuers are reduced

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

a. Reg S-X for financial items (eg, accounting requirements)b. Reg S-K for non financial items (eg., business plans)

2. (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)

a. Distinguish company vs. transaction info : info about specific transaction is disclosed in connection with that transaction (eg, type and feature of security, planned use of proceeds, UW compensation)

b. Only Certain Classes of Issuers Can used Integrated Disclosure: Content of RS prescribed by specific form that issuer eligible to use.

i. Use of certain forms: Distinguish forms based on (1) when required info must be presented in full to investor and (2) when certain types of info may be incorporated into RS from Exchange Act documents continuous reporting system w/o delivery to investors:

1. S-1 : (1) Certain reporting issuers may incorporate by reference into their S-1 info from their previously filed ’34 Act reports/docs. (2) Eligible issuers have filed at least one annual report and current in their reporting obligation under the ‘34 Act

a. Conditions for S-1: i. Must update for material changes not yet reported in a ’34 Act

report of some kind (10K, 10Q, 8K, etc.)

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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 EDiv. Must include list of incorporated reports and materials

1. NOTE: If the issuer is not eligible for these new S-1 options, presumably, they’re relegated to the old S-1 conditions: (1) Complete disclosure in prospectus; (2) No incorporation by reference; (3) Probably typically used in IPO situations

2. S-3 : Used by a registrant who has been in ’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

a. How Form S-3 works : (1) Info on registrant is fully incorporated by reference to ’34 Act reports; (2) Not req’d to include info on registrant in prospectus unless there’s a material change; (3) Relies on ECMH

ii. Even though permit integrated disclosure, different liability under ’33 and ’34 Act: 1. ’33 Act imposes strict liability on issuers if it involves misrepresentations in RS

and requires others associated with the RS and distribution to exercise due diligence to assure the accuracy of the RS to avoid sharing that liability

2. ’34 Act liability only flows from intentional or reckless conduct, and 10K’s/annual reports reflect lesser diligence in preparation, so not necessarily same quality of disclosure under ’34 Act

c. Gunjumping concerns for the seasoned issuer :i. Tension : Must make disclosures while in registration since have duties to

stockholders and other constituents, but don’t want to condition the market. SEC solution was to develop certain safe harbors for seasoned issuers to permit them to engage in disclosures while in registration and balance competing policy concerns

ii. Safe Harbors for Seasoned Issuers to Deal with Gunjumping: 1. WKSIs and FWP – Rule 163 : WKSI permitted to engage in unrestricted oral and

written offers via free-writing prospectus if made by or on behalf of the issuer.a. Written offer made prior to filing date must be filed “promptly” with

the SEC under Rule 163(b)(2) when RS ultimately filed and must bear the legend required in Rule 163(b)(1

i. Rule 163(b)(1)(iii) : Excuses “immaterial or unintentional” failure to include legend if good faith + reasonable effort to comply

ii. Rule 163(b)(2)(iii) Excuses “immaterial or unintentional” failure to file the communication with the SEC, if good faith + reasonable effort to comply

2. Reporting Issuers – Factual Business Info. + Fwd-Looking Info. to Investors (Rule 168): Announcements by reporting issuers that have engaged in the regular release of “factual business information or forward-looking information” will not be treated as an offer to sell a security (not apply to UW, only if by or on behalf of the issuer)

a. Requirements : (1) Must be the type of information issuer previously released in ordinary course; (2) Manner of dissemination must be similar to past releases of similar info

i. Factual business information = factual info about issuer, business/financial developments or product ads

ii. Forward Information = forecasts/future business plans

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b. Excluded from the safe harbor : Any communication about registered offering

3. Non-reporting Issuers – Factual Business Info. Released to Industry (Rule 169): (1) Only applies to factual information that is not forward-looking; (2) Intended audience must not be investors

4. Notice about Offering is Allowed (Rule 135): Not an offer if the issuer releases information about its operations and activities, even though the issuer is in registration

a. Rule 135(a) : issuers can disclose intent to make an offering, amount and type of security, manner and purpose of offering

i. Need a legend stating it is not an offerii. Cannot ID the UWs of offering price

5. Rule 433 and seasoned issuers : More liberal than with nonreporting company, can use FWP, must include legend, and provide URL for SEC website where can find RS and PR

iii. Research Reports and Reporting Companies: The following rules applies for research reports and reporting companies:

1. Non-participants can publish anything they want if they’re not getting paid (Rule 137): Applies no matter if issuer reporting company

2. Participants/non-participants can publish about different kinds of the issuer’s securities not included in the offering (Rule 138): If offering debt, can publish about equity and vice versa

3. Participating Broker/Dealers’ Research Reports (Rule 139) – Can’t use it for an IPO.

a. 139(a)(1) Focused reports : B/D, whether or not in distribution, may issue reports focused on the issuer provided the issuer meets requirements of Forms S-3 or F-3 and is not a bad actor. Must have previously distributed a report in the regular course of business

b. 139(a)(2)Industry reports : Broker/dealer can issue reports about the issuer’s industry; must be in the regular course of business. Issuer must be a reporting company & not a bad actor. Must contain info about other issuers in industry or be comprehensive list of securities currently recommended (no prominence for issuer)

E. Shelf Registration, pp. 192-99, Problem 4-34 a. Purpose of shelf registration: Permits company to preregister securities and then sell them

when (or continuously as) market conditions dictate. b. What is it: Shelf registration permits a registration of securities for later sale if the registrant

undertakes to file a posteffective amendment disclosing any “fundamental” change in the information set forth in the original RS.

i. NOTE: Language only requires amendments to the RS for “fundamental” changes and not for “material” changes

ii. Result: c. What Rules/Regulations do we care about: Rule 415, Form S-3, Item 512(a) of Regulation S-K,

Rule 430i. Shelf Registration – Rule 415 : Securities may be registered for an offering to be made

on a continuous or delayed bases in the future (both debt and equity securities), provided that the reg. statement pertains only to:

1. Securities to be sold by or on behalf of the registrant, 2. Securities to be issued upon conversion of other outstanding securities,

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3. Securities to be issued in connection with a business combination, 4. Securities the offering of which shall be commenced promptly , will be made

on a continuous basis, and may continue in excess of 30 days from initial effective date, O

5. Securities registered on the form S-3, which are to be offered and sold on an immediate, continuous or delayed basis.

ii. Timing and amount limitations on shelf registration: Rule 415(a)(2)-(4) 1. Two year rule : Securities not registered on a Form S-3 may only be registered

in an amount which is reasonably expected to be offered and sold within 2 years from the initial effective date.

2. Form S-K requirement: Registrant must furnish undertakings required by Item 512(a) of the Form S-K

3. Three years for shelf : Shelf registration only valid for 3 years from the initial effective date

iii. Item 512(a)(1) of Regulation S-K: Fundamental Change : Registrant undertakes to file a post-effective amendment to RS: (1) To reflect any fundamental change in the information set forth in RS, (2) To include any material information not previously disclosed

1. When would not apply : Requirements don’t apply if RS on the Form S-3 and info. required to be filed as a post-effective amendment is included in periodic reports that are incorporated by reference in the registration statement (more of an efficient market for WKSIs)

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

iv. Item 11(a) of Form S-3: Material Changes : Registrant must describe any and all material changes in affairs that occurred since end of last fiscal year for which financial reports were included in the latest annual report which have not been described in a report on Form 10Q (quarterly report) or Form 8K (significant events) To avoid costs, try to issue stock at same time as a 10Q comes out

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

1. In case of an Automatic Shelf RS : will be effective immediately2. In cases other than an Auto Shelf RS : issuer can keep issuing under old RS for

up to 180 days or until new RS goes effective, whichever soonervi. Amount of securities : Shelf registrations for non-S-3 filers limited to securities

reasonably expected to be sold within 2 years from initial ED of registration.d. Automatic Shelf Registration (for WKSIs) - Rule 405 : “Automatic shelf registration” means a

reg. statement filed on a Form S-3/F-3 by a WKSIi. What occurs : WKSIs may register unspecified amounts of different specified types of

securities on immediately effective Form S-3/F-3 (as of date of filing most recent shelf registration statement/amendment (later of))

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

iii. Flexibility : 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

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iv. 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. Can leave out (1) whether primary/secondary offering; (2) description of securities other than the class or name; (3) names of any selling security holders; (4) disclosure regarding any plan of distribution

v. Adding info : Can add omitted info to prospectus by (1) post effective amendment; (2) incorporation by reference into ’34 Act reports; (3) prospectus or supplement would be deemed to be part of an included in the RS

1. NOTE : this is a prospectus that can be used at all times except when final prospectus required

vi. 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

vii. Rationales for Auto Shelf Registration :1. Facilitate immediate mkt access & promote efficient capital formation, w/o at

same time diminishing investor protection2. 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

e. Certain Time Limits for Providing Missing Information for Shelf Registrations :i. Changes to the base prospectus – Rule 430B and 430C :

1. Rule 430B: WKSIs (430C is for Non-WKSIs) a. (a) Prospectus filed as part of shelf registration may omit information

unknown or reasonably unavailable to the issuer (price, primary vs. secondary, plan of dist., etc.)

b. (d): May be updated by (1) Post-effective amendment to the registration statement; (2) Prospectus filed under Rule 424(b); (3) Including in periodic reports, incorporated by reference into the prospectus

c. (f)(1): included as of first use of amended prospectus or first sale to which the subsequent form of prospectus relates

d. (f)(2): For purpose of Section 11 liability, the filing of an updated prospectus under these rules resets the liability clock for RS

e. (h): Where a form of prospectus is filed under Rule 424(b) but does not include omitted information because of its inclusion in period reports, such form of prospectus must be filed pursuant to Rule 424(b)(2), (b)(5), or (b)(7)

2. Rule 424(b)(2): Must file with the commission within 2 days of the earlier of the following two dates: (1) Determination of the offering price, or (2) Date it is first used in connection with public offering or sale

F. Updating and Correcting the Registration Statement, pp. 200-07, Problem 4-38 a. Issue: What is the issuer’s obligations to update its prospectus, and in turn its RS?b. What statutory provisions do we care about : Section 8

i. SEC Powers Under Section 8, incl. Refusal Orders & Stop Orders 1. Automatic Effectiveness - Section 8a : RS is effective 20 days after filing.

a. Rule 472 allows for permanent delaying amendment

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2. Refusal order - Section 8(b) : Limited use because it only reaches patent misstatements apparent on the face of the document

a. Small timing window: i. SEC must give notice of a hearing within ten days of filing date

& hearing must occur within ten days of noticeii. Rule 473 allows for permanent delaying amendment that

continuously tolls 20-day period that mitigates problem 3. SEC Approval of Amendment - Section 8(c) : Amendment filed after ED of RS

shall become effective on such date as the SEC may determine, having due regard to the public interest and protection of investors

4. Stop order - Section 8(d) : More frequently used than refusal orders. Empowers the SEC to act “if it appears . . . at any time that the registration statement includes any untrue statement of material fact.”

a. Notice : Serves notice to the public that SEC finds something materially false or misleading in the statement

b. Amendment : If/when RS amended in accordance with stop order, the order ceases. But if amendment is made before the stop order has been issued, the SEC can disregard the amended and proceed based on pre-amended statement (SEC gets a chance to publicize its disapproval to investors)

5. 8(e): Non-public investigations by the SEC : Stop order can be issued solely on the basis of the issuer’s failure to cooperate in an investigation

ii. Liability to Investors & SEC Powers 1. When registration statement is rendered materially misleading as of its

effective date: Purchasers look to 12a2; SEC uses 8a/20/17a2. Purchasers: Section 12(a)(2)” : Available for purchasers when RS became

misleading subsequent to its effective date3. SEC: Section 8A, Section 20 to prevent violations of 17(a) : Can use 8A to issue

a cease-and-desist order or invoke Section 20 to obtain orders in the fed courts to prevent violations of antifraud provisions in S17(a)

iii. Post-Effective Amendments 1. Issue : Does an amendment need to be filed? Consider both Materiality and

Substantive Changesa. Rule 424(a): Substantive Changes to Prospectus : Substantive changes

to a prospectus previously filed with the SEC as part of RS need to be filed as an amendment to the RS

b. Release No. 6276: A material change merits a post-effective amendment: New information Added to Prospectus → No post-effective amendment req’d; Liability clock gets reset when you file an amendment

2. Why would you amend a RS: a. Reason #1 - Registration statement Inaccurate when filed : Must

amend immediately to avoid Section 11 liability b. Reason #2 - Registration statement subsequently becomes

misleading (as of its effective date): Prospectus must be updated to avoid Section 12(a)(2) liability. Whether requires a post-effective amend. depends on material/substantive change

3. Use of Stickering - Rule 424(b)(3)-(5) : Non-material change allows for a sticker containing the new information, don’t need to file an amendment

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a. Post-effective amendments halt distribution efforts while SEC is approving; while waiting for the SEC to approve an amendment stickered prospectuses can be used

4. Section 10(a)(3): When registration statement > 9 months old : Where a prospectus is used more than 9 months after the RS has become effective, information must not be from a date more than 16 months prior to such use (but this new information doesn’t need to be filed as an amendment)

5. Undertakings to Update when dealing with Rule 415 Shelf Registration : Item 512(a) says these must be filed as amendments

a. Any prospectus required by §10(a)(3), to reflect any changes which represent a fundamental change in the registration statement’s information, or to include any material information or material change

b. Can be satisfied through ’34 Act filingsc. Any other changes can be made by stickering, don’t need to be filed as

an amendment6. Withdrawal of the Registration Statement

a. Rule 477: Withdrawl subject to SEC Approval : Issuer may withdraw RS or any amendment or exhibit thereto & its withdrawal is effective immediately unless the SEC objects within 15 days of the withdrawal application being filed

i. SEC has successfully denied withdrawal of a reg statement where registrant has sold securities covered by the deficient statement, and where the registrant has previously sold securities of the same class

ii. Even when the SEC allows withdrawal, it frequently publishes an opinion setting forth the deficiencies

G. The Trading Practice Rules, pp. 207-14 a. Issue: Substantial temptation by issuer and UW, as well as associates, to influence the

secondary trading market with public offerings so that it occurs more quickly or at a higher price. This lead to institution of certain “trading practice” rules to curb these abuses

b. “Purchases during distribution” : SEC proscribes bids and purchase of distributed security by the key participants in the distributing to prevent artificially conditioning the market

i. General Prohibition : Prohibition against bids and purchases during a distribution applies until the regulated person has completed his participation in the distribution (issuer, UW, b/d participating in the distribution)

ii. Relevant Rules : See 100-102 of Regulation M1. 102 : bids or purchases during distribution by the issuer or other person on

whose behalf distribution is being made2. 101 : bids and purchases by the UW/B/D or other person participating in the

distribution, and affiliated purchasersiii. Cooling off period and shelf registration : when do Rules 101 and 102 apply? potential

problem with 415 shelf registration1. Prohibition applies during restricted period for shelf registration : 1 business

day or 5 business days before the security’s price is determined or when person becomes a distribution participant

iv. Notable exemptions for transactions from prohibitions on purchases during a distribution: See regulation M

1. Rule 101b3/8 – syndicate/UW from issuer OK : Purchases among members of UW syndicate or by UW from issuer exempt

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2. Rule 101b5 – No solicitation by b/d, then OK : Any purchase on behalf of customer where order not solicited

3. Rule 101c/102d – if volume/grade requirements met, then OK : broad exemption for actively traded securities meeting certain volume requirements and investment grade securities

4. Rule 101b7 – de minimis : de minimis purchase exemptions if not exceeding 2 percent of average trading value

v. Laddering likely violates Regulation M : UW conditions allocation of shares in an IPO upon investor agreeing to purchase in the aftermarket ceratin amount of distributed security (likely violates Regulation M)

c. Stabilization: i. What is stabilizing : Pegging or fixing of a security’s market price through purchases or

bids for the limited purpose of preventing or retarding a decline in security’s price during a public offering of the security

ii. Why stabilization is necessary : Large amount of sell orders has destabilizing effect; provide some assurance of liquidity for investors who find it necessary to sell shares soon after they acquire them

iii. Rule 104 : Allows UWs to initiate and charge stabilizing bids based on the distributed security’s current market price in its principal market

1. 104f2i/4 : allows UWs to initiate and change stabilizing bids based on the current price in the principal market as long as it does not exceed the offering price

d. Global offerings and distribution rules: Trading practice rules apply when distribution participants in global offering occurs within the US. Problem with stabilizing prices on US vs. world markets.

i. Exemptions/Exceptions for global offerings: 1. 101c1: Regulation M says exempts Rule 101s proscription of trading purchase

during a distribution of securities that have an average daily trading volume of $1 million issued by a company and has public float of $150 million

2. 104fii: Allowing stabilizing prices to be determined not solely by the price in the security’s principal market when that market is closed

3. 104f5: adjustments permitted in the stabilizing rate to reflect exchange rate fluctuations

4. 104g: stabilizing purchases in connection with global offering do not violate Rule 104 provided that not SP’s occur in US and SPs in foreign market comply with provisions in other country comparable to Rule 104

CHAPTER 5&8 – Exempt Securities and Exempt Transactions

A. Exempt Securities :a. What is the scope of the exemptions (securities and transactions) : Two things to keep in mind

with exemptions:i. Point #1 - This is a REGISTRATION EXEMPTION : Exemption extends to registration

only and not exemptions from the antifraud provisions of the securities laws. 1. Reality : Even if exemption applies, (1) SEC can proceed against a seller under

S17 of the ’33 Act; (2) Purchasers of securities may have a private right of rescission remedy for misrepresentations in an offering (whether or not registered) that can be viewed as a “public offering”; (3) Rule 10b5 of the ’34 Act exposes all securities and sales purchases to fraud liability, including those exempt from registration.

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ii. Point #2 – Many small and intrastate offering may still be subject to blue sky laws : Even though preemption of many state blue sky laws, state regulation of many small and intrastate offerings exempt from federal registration may still have registration requirements that must be met under state law.

1. ALSO , all securities subject to state antifraud provisions, regardless of exemption from state registration requirements

b. Why have exemptions : Congressional determination that full blown registration for securities may be unduly expensive given investor sophistication, state securities regulation, or the issuer’s small capital needs.

i. ALSO may be put into play when other market or regulatory protectiosn would make SEC registration superfluous

c. What types of exemptions are available from the registration requirements : There are exempt securities (will always be exempt from registration, both when issued and later sold) and exempt transactions (only exempt when issued, may have to find another registration exemption when try to sell later or may violate S5)

SECTION 3 EXEMPTIONS

B. Section 3 Exemptions – Exempt Securities, pp. 429-35 a. Section 3 covers “exempt securities”: Exempt securities are always exempt from registration

both when issued and later traded i. Section 3a2 – Gov’t securities, bank securities, and collective, common, or single

trust funds: 1. Gov’t securities : Securities issued or guaranteed by governmental

organizations (federal/states/municipalities)a. Rationale: Character of issuer, political realities, constitutional

restraintsb. But see Rule 15c2-12: Securities firms that deal in municipal securities

must provide investors with an “official statement” for offerings above $1 million (under $1 million and private placements are exempt)

2. Bank securities: Exempts securities issued or guaranteed by banksa. Rationale: existing bank regulation that, at least in theory, other than

securities laws, adequately protects investorsb. What types of “banks” are exempt: National bank, or any banking

institution organized under the laws of a state of DC, “the business of which is substantially confined to banking and is supervised by the state or territorial banking commission or similar official”

3. Common/collective/single trust funds: Self explanatory, already regulated under other areas

ii. Section 3a3 - Short Term Commercial Paper and Short Term Notes: Exempts any note, draft, bill of exchange, or banker’s acceptance arising out of a current transaction if the maturity at the time of issuance does not exceed 9 months

1. When apply: Applying only to prime quality negotiable commercial paper of a type not ordinarily purchased by the general public

2. Rationale: Character of the issuer (prime quality requirement) and characteristics of the security (requirement that funds be used in current operations and that the maturity not exceed 9 months lessen the risk); these are sophisticated investors and don’t need regulation

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a. NOTE from Reves: Different treatment of 9 month of less instruments/notes in ’34 Act than ’33 Act, and here this is the ’33 Act exemption

iii. Section 3a4 – NonProfit Issuers: Nonprofit issues need not register their securities so long as none of the issuer’s net earnings benefit “any person, private stockholder, or individual”

1. Rationale: People invest based on charitable purpose and not motivated for returns; cost prohibitive for nonprofit issuers to register

2. Who gets exemption: educational, benevolent, religious, fraternal, charitable, or reformatory purposes (typically tax exempt)

iv. Section 3a5/3a8/3a2 – Securities Subject to Non-SEC Regulation: Some securities exempt on the theory that other regulations offer adequate proteciton

1. Exempted if : (1) Securities Issued by Savings and Loans, Cooperative Banks, and Similar Institutions (3a5); banks (3a2); tax qualified pension plans (3a2); certificates issued by trustees pursuant to court order (3a2); participation interests in RR cars of federally regulated common carrier (3a6)

2. 3a8- Insurance Policies and Annuities: a. Rationale: Already regulatory regime in place to regulate insurance ;

risk being assumed by the insurance company and not by the person who purchases the insurance policy or annuity

b. BUT Consider: Insurance policies marketed as money making devices, ways in which market products that include investment feature (eg, variable annuity policy), insurance reg as state func.

v. Additional 3(a) Exemptions: Certificates issued by trustees or receivers in bankruptcy (3a7); exemption for issuer exchanges with existing security holders (3a9); securities issued in corporate reorganizations (3a10); and intrastate offerings (3a11)

vi. Section 3b – SEC Power: SEC can exempt class of securities (up to aggregate of $5 million) if it find that enforcement of ’33 Act w/r/t securities is not necessary to protect the public interest b/c (1) small amount involved or (2) limited character of the offering

1. Section 3b Power: Has led to Regulation A, Rules 504 and 505 of Regulation D, and Rule 701

vii. Section 3c –SBIC: SEC can exempt securities issued by small business investment companies since no investor protection needed

viii. Section 28 – SEC power: Can exempt any person, securities or transaction” from “all or part of the ’33 Acts registration requirements

b. Why care about difference with security exemptions vs. transaction exemptions?: Transaction exemption focuses on the nature of offering with “transaction exemption” such that securities do not themselves become exempt.

i. Must find exemption for resale: If security is part of transaction exemption, each time they are transacted, the seller MUST find a transaction exemption to avoid registration OR must register the securities that wish to resell

ii. Burden of proving transaction exemption lies with proponent: Proponent of exemption has burden of establishing conditions of the exemption are met

1. Penalty if If don’t prove exemption applies : Have sold unregistered securities in violation of S5, also violate 12a1 and whole transactions can be unwound based on recission (all or nothing proposition)

SECTION 4 EXEMPTIONS

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C. Private Offerings, pp. 266-81, Problems 5-9 to 5-12 a. Private placement exemption appears in 2 places: private placement exemption for

registration appears under 4(2) as statturoy exemption that completely exempts issuer from all ’33 Act disclosure and registration requirements AND as Rule 506 to Regulation D, which provides clear guidance to issuers but mandates disclosure to certain investors

b. Section 4(2) Exemption – Private Placements: i. Statutory language of 4(2): Section 4(2) exempts from registration any offering by an

issuer that does not involve any public offeringii. Rationale: Unnecessary to register when investors on their own have adequate

sophistication and information to protect themselves c. What is the policy decision made under 4(2): Courts do not have dollar limit or investor limit

on private offerings and instead care about investor qualification. Courts have fashioned a sliding scale of investor sophistication and access to information about the issuer.

i. Burden: As with Section 3, burden rests with the proponent of the exemption to show that applies

d. What considerations do we care about in a private offering under 4(2): Number of factors that are considered when determining whether an issuer can claim the private placement exemption:

i. (1) Investor sophistication; (2) # of offerees (higher #, higher burden of proof on issuer to show all had access to info); (3) access to information; (4) disclosure of information (should make those required under Schedule A); (4) insider status/relationship to issuer; (5) size and manner of offering

ii. NOTE : These factors was based on SEC guidance PRIOR TO Ralston, and although still cite today, focus on inquiry today is on Ralston test to determine whether 4(2) applies

e. Ralston Test – Fend For Themselves: Private placement exemption under 4(2) applies when offerees are able to fend for themselves (just access to information)

i. Current incarnation of the test: Courts determine if investors can “fend for themselves” by looking at the investors ability to evaluate the investment (based on business and investment sophistication) and on his access to information about the investment (based on availability of information or the issuer’s actual disclosure).

1. Test: Must have (1) sophisticiated offeree PLUS (2a) registration statement quality disclosure OR (2b) effective access to registration statement quality disclosure

2. Applies to OFFERS and not just sales: Can only claim the 4(2) exemption if the issuer meets the sophistication + access requirements w/r/t all offers, not just sales, or the exemption is void for the entire issue.

3. Applies to ALL offers and sales: Person claiming 4(2) exemption must show that each purchaser and offeree meets the sliding scale test or exemption lost for entire offering

a. Consider CA5 holdings: (1) Sophistication but not disclosure = no 4(2) exemption (Hill York); (2) 4(2) does not depend on insider statuts, sophisticated outsiders can be qualified (Wolfe); (3) received registration quality disclosure but lacked sophistication (Continental Tobacco); (4) If have at least access to quality infor (insider status, family status, privileged relationship, or bargaining power) and sophisticated then don’t need actual disclosure (Dolan)

b. NOTE: Diff. circuits apply Dolan differently – CA8/CA5 deemphasize sophistication; CA10 emphasis on sophistication (relevant but not essential condition); CA9 says flexible test with sophistication as 1 of 4

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factors considered (others are # offerees, size/manner of offering; and relationship of offerees to the issuer)

4. How to determine investor sophistication: (1) Professional status and investment experience of the party; (2) agent, intelligence, wealth, and income of the investor; (3) specific activities of party, such as regular consultation with investment professionals, membership in investment groups, or personal review of accounting statements and recommendations

5. Role of offeree representatives: If an unsophisticated offeree is represented by a knowledgeable and disinterested expert, the sophistication of the expert may be imputed to the offered under Rule 506 (would not fall under the 4(2) exemption itself)

6. Risk: ABA says that total amount of $$ to be invested and likelihood that all or part lost should be considered (fall under Rule 506 analysis)

f. Resale of Securities Acquired in Private Offering Exempted Under 4(2): i. Issue : Whether any of the purchasers acquired the securities with a view to their

distribution, rather than as an investment.1. Resale ok BUT: Can resell securities acquired in private offering but a

determination that “investors” acting as conduits in public offering will retroactively negate the validity of the original transaction as a private placement

a. Steps to avoid negate validity of private placements: issuers take 3 steps: (1) Require purchasers to sign statements of investment intent; (2) Inscribe securities to disclose that they are unregistered and a transfer may take place only if specified conditions are satisfied; (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

g. Prohibitions and Restrictions with the 4(2) Exemption :i. Prohibition against general solicitation : Since all offerees must be qualified, there can

be no general solicaition with private placements. Public advertising and open investment seminars will eviscerate 4(2) exemption. Issuers normally making a private placement rely on securities firms to prescreen potential investors

ii. Resale restriction : See above, Investors who purchase in private placement cannot resell to unqualified investors, as this transfers the whole offering into a public distribution and the reselling investors into statutory UWs. Issuers will seek to restrict privately placed securities, which are known as “restricted securities”

D. Regulation D, pp. 281-313, Problems 5-13 to 5-25, 5-28 a. What is Regulation D: Gives detailed guidance on when an offering qualifies for 4(2) private

placement exemption (see Rule 506) and creates additional exemptions for “small offerings” as authorized by Section 3b (Rules 504 and 505)

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

ii. Rule 506 : Nonexclusive safe harbor for the private offering exemption of § 4(2).b. The three Main rules – 504, 505, and 506 of Regulation D

i. Rule 504 – Small offering registered or exempt under state blue sky laws: nonreporting companies seeking to raise capital for specific purposes can sell up to $1 million in securities in any 12-mont period

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1. Restrictions: No general solicitation/advertising, securities issued become restricted and subject to 2-year holding period or the securities must be registered

2. If small issuers want to avoid marketing/liquidity restraints: (1) Register under state blue sky law that requires public filing and presale delivery of substantive disclosure to investors or (2) limit offering only to accredited investors under state law exemption that permits general solicitations

3. Remember the conditions: (1) Up to $1M; (2) May sell to anyone; (3) No disclosure or sophistication requirements; (4) Solicitation and resale depend on state law.

ii. Rule 505 – Medium sized offering subject to SEC conditions: Companies that are neither investment companies nor bad guys under Regulation A can sell up to $5 million in securities in any 12-month period

1. Restrictions: NO general advertising/solicitations; can sell to unlimited accredited investors but only 35 nonaccredited investors. Securities becomes restricted securities.

2. Disclosure requirements: All nonaccredited investors must receive specified written disclosure and have an opportunity to ask questions of the issuer.

3. Remember the conditions: (1) Up to $5M; (2) May sell to unlimited AIs, < 35 non-AIs; (3) Only disclosure (not sophistication) requirement for non-AIs; (4) Bad boy disqualifier

iii. Rule 506 – Private Offerings Subject to SEC safe harbor conditions: Any company can sell an unlimited amount of securities under the same conditions as Rule 505 with one added condition – if any sale made to nonaccredited investor, each nonaccredited investor must have sufficient knowledge and experience in business and financial matters so she can evaluate the merits and risk of the investment (can be satisfied if issuer reasonably believes that NAI is sophisticated).

1. Nonexclusive safe harbor: An offering that does not satisfy Rule 506 may still satisfy 4(2) exemption.

2. Remember the conditions: (1) No limitation on amount; (2) Can sell to unlimited AIs and less than 35 non AIs; (3) AIs only get disclosure; (4) For non-AIs – must gets disclosure and be sophisticated

3. “Sophistication” Standard of Rule 506 : 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. Sophistication Requirement : Rule 506 requires either: (1) 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 (2) Issuer reasonably believes this is the case [505 and 504 do not impose this reqm’t]

4. Role of the Purchaser Representatives – 501h: "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:

a. (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;

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b. (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;

c. (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

d. (4) Discloses to the purchaser . . . any material relationship between himself or his affiliates and the issuer or its affiliates.

i. CONCERN : About conflict of interest (if work for issuer, etc.) but sometimes the situation (like close family relationship to investor) may mitigate that concern.

iv. Proposed Rule 507: 506 + general solicitation c. Sliding scale nature of regulation D : 506 (any size offering, most serious constraints,

sophistication std., affirmative disclosure, no more then 35 purchasers) 505 (offering up to $5M, affirmative disclosure, limitations on purchasers, eliminates requirement that purchasers/representatives be sophisticated) 504 (no disclosure or sophistication requirements or purchaser limitations but only for offerings up to $1M)

i. Cost of regulating small business offerings through 504 may exceed the benefits and justify an unconditional small offering exemption

d. Who are Accredited Investors – Rule 501(a) : Rules 505 and 506 permits unlimited number of AIs and only 35 non-AIs; neither requires disclosure to AIs but both mandate significant disclosure to non-AIs, and only 506 imposes sophistication requirements on non-AIs

i. Why important: Not included when calculating total number of investors, determine disclosure obligations under 505/506

ii. Burden on issuer : Issuer needs only to reasonably believe investors falls under the above categories

1. If only AIs in offering: 2. Unlimited #’s : 505/506 can have unlimited AIs w/o jeopardizing exemption3. No disclosure required: No disclosure needed for exemption;4. Sophistication presumed : Under 506, AIs = conclusively presume

sophisticationiii. Rule 501a: Categories of accredited investors include (1) Institutionial investors; (2)

Pension plans; (3) Venture capital firms (if invest + significant managerial assistance); (4) Corporations and other organizations exceeding a certain size; (5) Key insiders (D’s, EOs, and GPs of the issuer); (6) millionaires (net worth + $1 million; (7) fat cats (2 years of annual income of $200K); (7) Sophisticated trusts; (8) Accredited owned entity\

1. Groups worth highlighting : a. Executive Insiders of the issuer – defined in Rule 501(f) : “any

president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy making function, or any other person who performs similar policy making functions for the issuer”

i. Result: Non-wealthy insider may be considered an AIb. Wealth Test : AI when Natural persons with wealth or income

exceeding (1) Net worth > $1 million; OR (2) 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

i. Why consider wealth: (1) Ability to bear risk; (2) Small issuers unable to attract AIs have to deal with more disclosure and sophistication requirements

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ii. Concerns with wealth test : (1) Liquidity (assets may be nonliquid yet considered); (2) Honesty of alleged AI (issuer no audit alleged AIs, rely on AI if no red flags)

2. Possible reform: (1) Additional category of wealth-based accredited investor keyed to “investments owned standard” ($750K in investments) and incorporate inflation adjustments; (2) Rule 507 same as 506 + permitted limited advertising for “large accredited investors” (higher $$ thresholds)

e. Calculating the Number of Investors :i. 35 Purchaser Limit Under 505/506 : Only available if # of purchasers (non-AIs) does not

exceed 35, or alternatively, that issuer reasonably believes that # of purchasers does not exceed 35 (non AIs)

1. Who is excluded: AIs, trusts or estates in which have beneficial interest exceeding 35%, spouses and certain relatives of purchasers, corporations or other orgs in which purchasers are at least 50% owners;

2. Entities: Corporations/partnership/other entity that not accredited counted as single purchaser unless formed for purpose of purchasing securities in the offering

3. No double counting: Singe nonaccredited investment decision, carried out through diff. channels, gets counted as 1 non-AI

f. Prohibition Against General Solicitation: Reg. D does not prohibit offers to non-AIs but it does prohibit general solicitations or general advertising in 505/506 offering, as well as 504 offerings not subject to state law that permits such solicitations

i. When is solicitation not general: Prohibition requires that the issuer (or person acting on its behalf) have a preexisting relationship with each offeree. Meant to ensure issure/financial adviser knows the investment sophistication and financial circumstances of all offerees (mandates suitability screening before any Reg. D solicitation).

1. Potential problem with solicitation ban for issuers: Forces issuers to hire securities firms to market their Reg. D offerings since issuers rarely have own list of qualified investors

ii. What statutory section do we care about with the solicitation ban: Look to Rule 502 and 504

1. No general advertising - Rule 502(c): Must be satisfied for Reg D exemptions to apply. Prohibits issuer or anyone acting on its behalf from offering to sell securities by any form of general solicitation or general advertising. (“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 …”

2. Prohibitions sometimes don’t apply for 504 offering - Rule 504(b)(1) : Prohibitions on general solicitation and advertising are not subject to 502(c) if they are made (a) Exclusively in one or more states that require registration & filing of a substantive disclosure document; or (b) In one or more states, as long as (1) at least one state has requirement of registration & filing of substantive disclosure document AND (2) it is delivered before sale to all purchasers; or (3) Exclusively under state law that permits general solicitation and advertising as long as sales are made only to accredited investors.

iii. What will violated the solicitation ban under 502c : Advertisements, articles, notices, seminars/meetings whose attendees have been invited by any general solicitation or general advertising

1. Easy cases: Mass mailings are general solicitations

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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) – info about offerings sent

to 6 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 offeree a. Preexisting relationship : 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

4. Broker Dealers and Preexisting relationship: a. B/D can provide pre-existing relation b/w issuer and offeree:

i. 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

b. BUT relationship must be est. PRIOR TO time B/D began work on the Reg D offering: Cannot offer securities that the firm was offering or contemplating offering at time of the questionnaire

iv. Internet solicitations/pre-qualifications 1. 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.”

2. IPONet No Action Letter (1996) : Inline information can be distributed re: offerings if:

a. Online questionnaire allows broker to determine whether the investor is accredited [under 501a] or sophisticated [for 506]

b. Broker verifies the information provided by the investor, andc. Investor is given password access to page where offerings posted

subsequent to the investor’s registration are listed3. 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

v. Rule 135c Safe Harbor : Issuers needed convey some information about their offerings to inform existing shareholders of change in business/direction. Cannot be used to “condition the market” for the offering

1. L imited information allowed under 135c : (1) name of issuer, (2) basic terms of securities offered, (3) brief statement of the manner and purpose of the offering, (4) without naming the underwriters or price

vi. Calls for Reforms: Problems that solicitation ban poses (1) hardship on small issuers w/o pre-existing relationships; (2) focus on offerees not purchasers; (3) uncertainty in communication

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g. Disclosure obligations – 502b: No disclosure in 505/506 offerings if made exclusively to accredited investors (still antifraud applies). If nonaccredited, then disclosure obligations to all nonaccredited investors becomes mandatory

i. Breakdown for disclosure: 504 (no disclosure); 505 (yes to non-AIs, no to AIs); 506 (same as 505, yes to non-AIs, no to AIs)

ii. Policy balance : Providing investor protection (mandatory disclosure) and purpose of 505/506 (permit small issuers to raise capital in cost-effective way)

iii. What disclosure must be provided :1. Reporting company : Must provide ’34 Act filings2. Non reporting company : Must disclose under Rule 502(b)(2)(i):

a. Non-financial info : RS if offering is $5M+, or Reg A offering if < $5Mb. Financial information : (1) < $2M – balance sheet audited and dated

within 120 days (Regulation A offering circular, with financials required of SBIs); (2) $2M <> $7.5M – audited financial statements (Part I of registration form for which issuer eligible, with financials required of SBIs); (3) > $7.5M – extensive/full audited financials (Part I and financial of the registration form for which issuer eligible)

iv. How status of the investor impacts disclosure : (1) Non-AIs are entitled to any info given to AIs (502b(iv)); (2) AIs and Non-AIs entitled to ask questions (502b(v), must give each purchaser chance to ask ?s and receive answers and obtain additional info that may be provided w/o unreasonable effort/expense.

h. Limitations on Resale – Rule 502(d): Securities sold in 505/506 offering, as well as a 504 offering not subject to state law that permits resales, have the 4(2) status of restricted securities and cannot be resold w/o (1) registration or (2) further exemption.

i. Reasonable Care requirements – 502d : Reg D requires issuers to take “reasonable care” to prevent unregistered, nonexempt resales through letters of investment intent, disclosure of restrictions, and legends.

1. Rule language : 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.

i. Integration vs. Aggregation i. Integration: All offers and sales that are a part of the Reg D offering must meet all the

conditions of the relevant exemption. Transactions are integrated if they meet the SEC’s five-part test. Safe harbor against integration for sales 6 months before/6months after the Reg. D offering.

1. Impact of integration: Treats two offerings as one for purposes of determining availability of an exemption (eg, if one offering made as 3(b) offering and other not, deemed integrated, fail exemption)

2. Six Month Safe Harbor : 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

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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 within the 6 month window, must apply five-part test to determinate whether integration: BUT If you are within the 6 month window (no safe harbor applies), the following factors will determine whether the offering will be integrated (from Release No. 33-4552):

a. Factor #1 - Part of a single plan of financing: Whether multiple offers are part of a single plan of financing

i. 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. Factor #2 - 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. Factor #3 - Sales made at or about the same time : 6 month lapse

creates rebuttable presumption against integration. 1 year lapse may make the presumption irrebuttable

d. Factor #4 - Same type of consideration given : i. 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. Factor #5 - Made for the same general purpose: i. May be same as the first factor (single plan)

ii. Donohoe v. Consolidated Operating & Prod. Corp. (7th Cir. 1992) = best case; “suggests a level of generality to the integration analysis” – that each partnership in the case was to drill for oil was enough

1. 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

4. Purpose of the integration analysis: Test asks whether there was one financing

a. Contrast with integration of issuers: See SEC v. Murphy, arises when offerings by distinct and separate issuers are integrated and treated as an offering by a single issuer, LP interests should have been registered, company, rather than individual partnerships was the issuer (above we are talking about integration of OFFERS, and not ISSUERS – keep these separate)

5. Private Followed by Public Offering – Rule 152: SEC permits an issuer to make a private placement under 4(2), which includes 506 offerings, and then subsequently initiate a public offering without the two being integrated.

a. NOTE: Planning activities for a second offering that take place while the first offering is still open do not in themselves render Rule 152

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unavailable. Companies contemplation of filing ’33 Act RS for public offering at the same time as conducting 4(2) private placement would not cause 4(2) to be unavailable.

b. RS could be viewed as general solicitation: RS can be seen as impermissible general solicitation, but must determine whether would make 4(2) unavailable by determining (1) whether investors in private placement were solicited by the RS or (2) through some other means that would otherwise not foreclose the availability of the 4(2) exemption

i. Example: If private placement investor becomes interested in concurrent private placement through some means other than RS that did not involve general solicitation and was consistent with 4(2), such as through substantive preexisting relationship with the company or direct contact by the company/agents outside of public offering effort, then prior filing of RS Would not impact 4(2) exemption for private placement

c. Only applies to 506 : Rule 152 provides protection for offering under 4(2), which includes Rule 506. It is not available for offerings under other exemptions, including 504 and 505

d. When might be unavailable: (1) Filing of RS subsequent to first offering if those in 1st offering unconditionally bound; (2) Any renegotiation of 1st offering after RS for second offering filed

6. Integration of Abandoned Offerings – Rule 155: a. Arises in two situations : (1) issuer decides to abandon private offering

in favor of raising more capital through registered offering to the public, or (2) abandon efforts to sell securities through public offering and seek more modest amount in private placement of securities

b. Thrust of the rule: Safe harbor for registered offering following abandoned private offering or private offering following abandoned public offering. NO integration the registered or private offering in either case

c. Abandon Public for Private – Rule 155 : Permits an issuer that commenced a registered to offering to withdraw the RS before any securities are sold and then begin a private offering. Must be 30-day cooling off period b/w RS withdrawal and private offering commencement. Must provide each offeree with info on withdrawal/fact that unregistered/legal implication of unregistered status, and must disclose any material changes in issuer’s business/financial condition (if any) after withdrawal of RS.

d. Abandon Private for Public – Rule 135 : Any private offering that relies on 155 must satisfy the conditions of a private offering exemption so that private offering is bona fide at the moment it was abandoned. Issuer must have terminated all activity w/r/t private offering and prospectus filed must state that abandoned private offering for public offering. BUT no cooling off period as with public private offering if all offerees were AIs or sophisticated

e. Limits on Rule: Private offering includes offerings exempt under 4(2) and 4(6) and 506, but not rules 504/505

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ii. Aggregation : Calculation of whether the amount to be financed in a 12-month period exceeds the 504/505 dollar limit. 504 and 505 cap the aggregate dollar amount that issuer can raise in any 12-month period.

1. Impact of Aggregation : Add up the totals for 3(b) offerings. If other offerings are made, and are separate, they don’t count towards the aggregate.

2. Limitations on dollar amounts – 504 and 505 : Rule 504 and 505 limit the total offering prices within a 12 month period

a. Limits : Rule 504b2 = $1M; Rule 505b2 = $5Mb. Formula to determine the cap:

i. Offering price of all securities sold under 504/505 + (PLUS)ii. Offering price of all securities sold w/in previous 12 months in

reliance on any §3(b) exemption –504/ 505/Reg A/Rule 701 + (PLUS)

iii. Offering price of all securities sold in previous 12 mos. in violation of the §5 registration reqm’ts (nonexempt offerings count against the 3(b) cap)

3. Calculating value, Rule 501(c) : Cash is best; If 50% cash & 50% other, take 2 * Cash = 100% value of offering (501c); If all non-cash, determine by bona fide sales of consideration or “FV using accepted std”

4. Timing: Past 12 months + offering period : 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)

E. Intrastate Offerings, pp. 253-66 a. The intrastate offering exemption - 3a11 : ’33 Act exempts from registration purely local

offerings – those by in-state issuers to in-state residentsi. Language of the Rule : 3a11 exempts any security which is (1) 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, or (b) if a corporation, incorporated by and doing business within, such State or Territory

ii. This is transaction exemption, not securities exemption : Despite placement in Section 3 (Exempt Securities), 3(a)(11) is effectively more like a transaction exemption (resales aren’t automatically exempt)

b. Interpretation of the exemption: Construed by courts narrowly and strictlyi. All local requirement : Must sell exclusively to residents of single state- usually for

local financing of local business via local investmentii. “Part of an issue” : Looks to facts on whether part of plan or program; no exemption is

combined with different parts of single issue where some sold to nonresidents; voids all of intrastate exemption

c. In-state issuer : To get 3a11 exemption, issuer must be “person resident and doing business within the state” of the offering.

i. Reside : Corporation resides in state of incorporation1. Factors to consider : (1) Residence is more than presence; (2) Formal

representations of residence and agreements not to resell to nonresidents are not enough w/o more; (3) If offering large enough from start, questions if it will be successful as local offeri

a. 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

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ii. Doing Business in State: revenues, assets, principal office, and use of offering’s proceeds are principally in-state

1. Some factors to consider: (1) Substantial operational activities (not just bookkeeping, etc.); or (2) Business activity in the state must be “predominant,”; (3) Can’t rely on exemption if used for new business outside of state and unrelated to business locally conducted; (4) Not valid for series of corporations in different states where they constitute single venture

iii. Look to Rule 147 – Residence and “Doing Business” Guidelines: 1. Residence: Defined of noncorporate issuer as state where issuer organized, or

if an unorganized partnership, where principal business2. Doing Business: Quantitative guidelines, DB in state if principal office in state

and 80% of gross revenues/consolidated assets/intended use of offering’s net proceeds are within state

d. In-state offering: 3a11 requires that issue may be “offered and sold only to persons resident within a single state.” No qualitative or numerical limits on in-state offerees or purchasers.

i. Must be ALL offerees/purchasers: All offerees/[purchasers must have actual residence/domiciliary intent in the issuer’s state. Exemption lost if ANY sale or ANY offer (even one that does not result in a sale) is made to an out of state resident.

ii. Come to rest requirement: Issue cannot rely on investment representations by in state purchasers who buy with a view to distribute to out of state investors, but in state purchasers can resell to out of state purchasers if the securities have come to rest with them prior to the sale.

iii. Look to Rule 147 – Residence and Come To Rest: 1. Residence : Individual (actual principal residence); Business (principal office)2. Come to rest : Can resell after 9 month holding period, BUT even one out of

state offer or reseale voids the rule’s exemption if it occurs during 9 month period

e. Marketing/Offers: Target in state only, Okay as long include a disclaimer; but should show method reasonably aimed at in-state residents; can use intrastate modes of communication (mail/phone/etc.)

f. Resales - Needs to “come to rest” in state before resale out of state : Time between sale and resale a primary factor; needs to not be part of primary distribution

i. Statutory Test : Whether purchaser bought with intent to invest, e.g., hold for substantial time

1. Resale within 1-2 years suspect, burden of proof on seller2. Investor change of circumstances may shift burden3. Broker can be out of state but must sell to residents)

ii. Release 4434: Securities that actually come to rest in hands of residents who purchase without a view to resell may be resold without voiding exemption

iii. Rule 147 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)

1. Remember Sections 4(1) & 4(2) Exemptions from §5 Liability : Only applies to issuer, underwriter, or dealer.

a. Can escape liability if you can show that you are not an underwriter (defendant has the burden of proof)

b. Different courts have different tests; generally an intent to resell within 1-2 years is the gray zone

2. Placement in §3 means they are exempt from all liability except for 12b2 and 17(a)

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3a11 Rule 147Scope of offering (integration) All securities offered as “part of an

issuer” are integratedSet of sales separated by 6 months not integrated

In state issuer Resident and doing business w/in the state

Pricnipal office w/in state and 80% gross revenues/assets/proceeds used w/in state

In state offerees Offerees must be domiciled w/in the state

Offerees must have principal resident w/in the state

Restriction resales Securities must come to rest before resale

Nine month safe harbor holding period

g. Rule 147 Safe Harbor : Offers and sales made in accordance with 147 provisions qualify for 3(a)

(11) exemptioni. Part a- Transactions Covered- transactions within 3(a)(11): 3a11 covers the

transaction and not securities even though in Section 3ii. Part b- Part of an Issue (Integration Safe Harbor) : Must be a 6 month separation

between intrastate offering and an offering that would not qualify under the intrastate exemption (see 5 factor test if within 6 month period)

iii. Part c- Nature of Issuer 1. Resident of state if: (1) Incorporated or organized under that state

(corporation); (2) principal office (noncorporation); (3) principal resident (individual) [note just says “residence” and not “principal” in 3a11

2. Doing Business in state if at the time of the offering : Triple 80 Test, principal office + 80% gross revenues/assets/proceeds in state

iv. Part d- Offerees and Purchasers; Person Resident : Resident for offeree or purchaser if: (1) Corporation, partnership, organization has principal office in state; (2) Individual has principal residence; (3) Business organization organized specifically to acquire part of an issue must have all of its beneficial owners in a state

v. Part e- Limitation of resales : 9 month period from last sale by issuer before can sell out of state, can always sell in state, if someone sells within 9 months it destroys exemption for the entire offering & exposes issuer to liability for failure to meet registration requirements

vi. Part f- Issuer Precaution against interstate offers and sales 1. Issuer shall (1) notice on securities that unregistered and resale limits; (2) sop

transfer; (3) get written reps as to resident’s in state residencevii. Odds and Ends about 147 : (1) Nothing in 147 about disclosure to investors; (2) applies

to issuer and affiliates; (3) May lose exemption if through an “innocent and immaterial” deviation (unlike Regs D and A)

viii. Ideas for reform : (1) “Substantial compliance” provision so can’t inadvertently fall outside 147; (2) Purchases not offerees; (3) Resale ban should be lowered; (4) Doing business test 50% rather than 80%; (5) Exemption for major metro areas when cross states

F. Regulation A, pp. 319-24 a. What is this exemption: Administrative exemption promulgated pursuant to 3b of ’33 Act,

which authorizes SEC to exempt from registration class of securities if aggregate offering price of the issue does not exceed $5M in any 12-month period. Results in unrestricted securities and is available for primary and secondary offerings. This is a small offering exemption.

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b. What is the substance of Reg. A: Offerings are exempt from registration if the issuer uses an “offering circular” and complies with filing and circular delivery requirements that mimic those of Section 5.

i. Offering circular: Simplified disclosure document that permits issuers to choose either a registration type or question and answer format.

ii. Financial information : Required for inclusion but does not need to be auditediii. Sales: May commence 20 days after the filing or any amendment.iv. Waiting period: Can use preliminary offering circulars during the waiting period before

the offering qualifies for sale.v. Testing the waters: Regulation A permits issuers to test the waters and solicit investor

interest before filing an offering statement. This can be written or broadcast. Will be subject to antifraud provisions and must be filed with SEC before use. Will not be deemed prospectus

vi. Aggregate offering limitation: $5M in 12-mont period.vii. Secondary offerings: Can be used for 2ndary offerings up to $1.5M.

viii. Resales: Any securities sold are not restricted, which menas they can be resold immediately

ix. Solicitation ok: No limitations on general solicitations in Reg. A offeringx. Integration: No intergration for Reg. A if abandon and do registered offering if at least

30 days b/w last solicitation of interest and filing of RS1. What is seek to do Reg D. : Should wait 6 months, not 30 day since will likely

be integrated.xi. Substantial compliance: Will not lose Reg A. exemption if substantial compliance

(good faith, deviation insignificant to whole offering)c. Who can use Regulation A: Nonreporting US and candian issuers that are not disqualified as

bad boys: (1) pending SEC review, (2) SEC orders in last 5 years; (3) conviction/enjoin for fed/state securities violations last 5 yeasr, (4) execs/10% shareholders SEC sanctiosn or court order, or (5) issuer who uses tainted UW.

d. Where useful: Small national offerings to many investors over the internet. i. Why good: easier disclosure stds, flexible SEC staff review, can test waters, no

reporting requirements unless hit 500 shareholders and assets that exceed $1M, no S11/S12a liability, lower filing fees

ii. Why potentially bad: Blue sky registration required in states where offered, difficult to resell since lack of liquid 2dary market

Chapter 6: Secondary DistributionsA. Secondary Distributions:

a. Issue: When sales of securities by non-issuers are within the reach of Section 5i. Primary offerings: sales of securities by issuers

ii. Secondary distributions/trading transactions: Resales of restricted securities or the sale of securities by control persons

b. Types of transactions other than those by the issuer that must potentially comply with Section 5: (1) Persons acting as agents for the issuer; (2) Persons who previously purchased securities from the issuer in private transactions (‘restricted securities’); and (3) Persons in a control position with the issuer (‘control persons’)

i. Common thread : Sales and offers to public investors by persons with informational advantages similar to issuers may pose many/most of the same risks of a traditional primary offering by the issuer

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ii. Remember the importance of Section 5 : Every sale of a security must be either registered or exempt. The burden is on all who sell or even offer to sell to prove compliance with Section 5.

c. Problems that arise with secondary distributions :i. Transaction exemption does not apply to underwriters : 4(1) exempts transactions for

everyone except “issuers, underwriters, or dealers”, and must look to 2a11 to determine whether this person falls within the statutory definition of underwriter (broad term as defined in 2a11 of the ’33 Act)

ii. Resale destroying registration exemption : Does the resale of a security destroy the exemption the issuer relied upon when it sold that security without registration? (

1. Ex .: private offering under 4(2), sell to sophisticated investor, then investor turns around and sell to someone who does not satisfy Ralston criteria.

2. Ex .: Intrastate exemption, resale to one who has different residency may disqualify an offering initially exempt under 3a11

3. Coming to rest : Resale alone may not destroy, critical inquiry whether from the surrounding circumstances can conclude that issuer’s offering had come to rest

iii. Regulation of control persons : Control persons’ public offerings are within reach of Section 5, as those who purchase or sell from a control person are underwriters when the purchase/assistance is part of the control persons’ distribution, thus does Rule 144 apply?

iv. Resale by brokers, who are considered dealers under the ’33 Act : Brokers don’t have broad exemption under 4(1) since considered a dealer, so necessary to determine what their disclosure and registration obligations are (eg, duty to deliver prospectus even if not participating in the offering? Also problem if acting as broker/dealer on behalf of control person, as can be considered UW if resales part of a distribution

v. Does the Rule 144 Safe Harbor apply : applies to both resales of restricted securities and sales of securities on behalf of control persons, provides certainty in determinine who will be considered UW

1. Also look to see if 144A applies (large financial institutions) OR whether 4(1½ ) exemption applies

d. Important definitions :i. Control securities : Securities owned by a control person who is an affiliate of the

issuer. 1. Affiliate : Any person who directly or indirectly controls the issuer (405).2. Control : Possession, direct or indirect, of the power to direct mgmt and

policies of the issuer, whether through ownership of voting securities or otherwise (405).

3. Regulatory concern : Exploitation of superior information position, such that need regulation of control persons similar to issuers.

ii. Registered securities : Securities originally acquired in a nonpublic offering, either from the issuer or a control person, may not be resold into public trading market without causing purchaser-reseller to be treated as conduit for issuer or control person. Can be acquired by 4(2) private placement, Reg. D offering, transactions meeting conditions of 144A

1. Restricted character regardless of seller : Securities retain restricted character whether acquired from issuer, control person, or in chain of transactions.

2. Regulatory concern : Although holder of restricted securities may not need S5, public investors who cannot fend for themselves do need registration when the purchase restricted securities.

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B. The Underwriter Concept and Sales for an Issuer, pp. 337-45, Problem 6-1 a. Section 4(1) as Boundary W/ Regulated Public offering and Unregulated Market Trading:

“Provisions of Section shall not apply to . . . transactions by any person other than an issuer, underwriter, or dealers”.

i. Result of 4(1): Transactions by issuers, UWs, and dealers are subject to ’33 Act registration.

ii. Issuer: Ever person who issues or proposes to issue a security. Person or entity who becomes bound to the package of rights that inhere in the ownership of a security.

iii. Dealer: Securities firms engaged in an offering subject to registration.b. Main issue- what is an underwriter as per 2a11 : 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

i. What is means: 1. (1) One is not an underwriter if his participation in a distribution involves

earning a usual and customary retail commission (securities firm does not become statutory UW by participating as a retail broker or retail dealer in public offering); and

2. (2) If someone performs certain activities for a control person, that person becomes a statutory underwriter, 4 roles qualify a person as UW:

a. #1 - Any person who purchases from an issuer with a view to distribution of a security (VIEW TO DISTRIBUTE)

b. #2 - Any person who offers or sells for an issuer in connection with a distribution (AGENT)

c. #3 - Any person who has direct or indirect participation in 1 or 2d. #4 - Any person who directly or indirectly participates in the

underwriting of such an undertakingi. Connection to the distribution is key : Buying/selling is not

enoughii. Another Exemption : Average members of the selling group,

are not UWs if they don’t receive commissions beyond the normal dealer commission

3. (3) There are also 4 additional categories of UWs:a. #5 - Any person who has purchased from a [control person] w/a view

to… the distribution of a security [UW FOR CONTROL PERSON]b. #6 - Any person who “offers or sells for [a control person] in

connection w/the distribution of any securityc. #7 - Any person who “participates or has a direct or indirect

participation in any such undertaking”, ie. 1-2d. #8 - Any person who “participates or has a participation in the direct

or indirect UW of any such undertaking”, ie. 1-2ii. Result of 2a11 : There are 3 major categories of UWs that will satisfy the statutory

definition:1. Agent for issuer: Those who offer or sell “for an issuer” in connection with a

distribution of securities (#2) 2. Purchaser from issuer w/a view to distribute: Those who purchase from an

issuer “with a view to” the distribution of securities (#1). a. Resale of restricted securities

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3. UW for control person: Those who perform these distribution activities in connection with a control person (#5/36)

a. Resale of control securitiesiii. Definition of distribution : Meaning of UW turns on specified activities in a

distribution. Distribution not defined in statute or by SEC, but it is understood as meaning “any offer or sale to public investors.”

1. Includes : Public offering by issuer, secondary transactions through a broker, on a security exchange, or to an investor unable to fend for himself.

C. Category #1 - Agent for Issuer considered to be “participating in the underwriting/distribution”: The first category of statutory UW is the person who sells or offers “for an issuer” (eg, IBanker in best efforts offering who for a fee entices investors who then purchase directly from an issuer)

a. Huge reach of UW definition : See SEC v. Chinese Consolidated Benevolent Ass’n (2d Cir. 1941, unregistered Chinese gvt bonds, CCBA of its own initiative facilitated sales in US, CCBA was a UW and violated SA §5(a))

i. Rationale : 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

1. 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

2. Even if CCBA was not UW, it still was “participating in a transaction with an issuer” by funneling the money (steps necessary for distribution)

ii. Dissent : Concerned statute too broad; worried newspaper editorial urging purchase of bonds based on patriotism would make the paper an underwriter,

1. Here there was no relationship b/w the issuer and the supposed UW, words “for an issuer” implies some relationship b/w person making the solicitation and the issuer

b. Expansive interpretations of “participates” i. Participates in a distribution :

1. See 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

ii. Participates in an underwriting : 1. See Harden v. Raffensperger (7 th Cir. 1995), Conducting due diligence on

offering was enough to “participate in an underwriting” since it was a step necessary for the distribution

2. See Rule 142, old fashioned UW where agree to purchase any shares that cannot be sold in the offering, limited exemption if purchase for investment and agreement to purchase not with the issuer (eg, with institutional investor and UW where will purchase what not sold to public)

3. See Byrnes, CA2, 1977, exercised K right to include unregistered shares in RS filed by company RS ID’s plaintiffs as UWs, plaintiffs did not assist issuer in offering, yet were still found to be UWs

4. See SEC v. NA Research, CA2, 1970, requiring that have provided assistance and facilitated the distribution in order to “participate”

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D. Underwriter b/c “Purchased from an Issuer /a View to Distribute” : Person who purchases securities from an issuer with the purpose of reselling them to public investors (eg, IBanker in firm commitment UW that purchasers from issuer and resells allotment to retail dealers or directly to investors)

i. NOTE: Intermediary need not be securities firm or major investor, as even person who purchases securities in private placement and then resells in a public trading market is UW if purchased with a view to resell to public investors

ii. Language of statute : UW one “who has purchased from an issuer with a view to . . . the distribution of any security”

b. Meaning of “Purchase” under 2a11 : Not defined in the Act, but a sale requires the disposition of a security “for value” (§2(a)(3))

i. 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)

ii. 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

c. Meaning of “With a view to … the distribution” of the security : Seller must have purchased with investment intent or else resale violates §5

i. Objective test for investment intent – 2 factors :1. Factor #1 - Length of Time :

a. <1 year : might be able to show lack of investment intent, but it would be really difficult and is extremely rar

b. <2 years : presumption against investment intent, but may show by change of circs (below)

c. 2-3 years : investment intent is presumed (BUT rebuttable)d. >3 years : investment intent is established (irrebuttable)

2. Factor #2 - Change of Circumstances: [NO LONGER VALID POST-144] - Change in Purchaser’s (NOT issuer’s) circs may be considered to show investment intent. Must be “basic and unforeseeable” (e.g., sale made to satisfy unexpected call by bank of demand note)

a. 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, Will 2d Cir, 1959, CB 345

ii. No violation unless there is a distribution 1. 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

a. “A distribution exists if there are sales to those who cannot fend for themselves”

b. 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!

i. For resales of registered securities by non-controllers, there’s no resale Q b/c the RS applies

ii. For resales by non-controllers, there’s no distribution Q, if there is investment intent

iii. If a non-controller can’t show investment intent, we enter the distribution inquiry

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iii. Alternatives, if you can’t prove investment intent and you can’t show securities were at rest:

1. Intrastate : If the person bought the securities in a 3(a)(11) intrastate offering, he can resell to anyone who would have qualified under the original exemption

2. 4(2) private placement : If the person bought as part of a private offering, he can resell to buyers who satisfy the original private offering exemption and meet the Doran/Rahlston test for information + sophistication.

3. Reg D. not available : You may not use Reg D to get a resale exemption b/c Reg D is only for issuers.

iv. Summary : Resale by a non-control person: 1. First look to investment intent (i.e. holding period of some sort) 2. Then if investment intent not present, look to whether it’s a distribution i.e.

whether resale destroys the exemption under which issuer initially sold offering.

E. Underwriter for the Control Person: 4(1) defines UW as those persons who act for a control person in a distribution or who purchase from a control person with the view to distribute. This makes securities professional who assist control persons in dumping their stock into public market, without registration, liable as statutory UWs.

a. Distinguish from normal purchasers: 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):

i. But sometimes on same footing : (1) Same position as other holders of exempt securities that can sell if meet exemption for registration, and (2) Control persons may rely on 4(2) transaction exemption for IMMEDIATE resale if to Ralston Purina (i.e. fend for themselves) qualified purchaser who would not destroy the issuer’s exemption.

1. Remember : 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)).

b. How to define “control person”: 2 definitions matter for CPi. Rule 405 and control: One who directs or has the power to direct the mgmt and

policies of the issuer, whether through stock ownership or otherwise common control with the issuer

ii. Signatures and control : One who has the power to obtain the signatures required to sign a registration statement

c. Leading case with control persons – Wolfson, CA2, 1968 (liability of control persons) : W was company’s largest SH (40% interest). Sold >50% of his shares through various different brokers.

i. W’s liability -- 3 steps :1. W is a controller is a §2(a)(11) statutory issuer. 2. If W is §2(a)(11) issuer, brokers are §2(a)(11) UWs3. If brokers are §2(a)(11) UWs, then the stock was sold in “x-actions by UWs”4. X-Actions by UWs d/n enjoy the exemption of §4(1)5. W/out the §4(1) exemption, the transaction violated §5.

ii. Broker’s Exemption : The brokers, however, are shielded by §4(4) broker exemption1. But, W c/n rely on §4(4) broker’s exemption, since the broker’s exemption

applies only to brokers.a. 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”)

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b. 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

iii. Rationale for control person’s rule : (1) Concerned that CP will take advantage of investors -- information advantage; (2) Other ways for CPs to make public offerings

F. PIPEs Transactions : Public company sells equity securities in a private transaction (usually Rule 506) and then immediately registers the shares for resale to the public.

a. Why not sell the shares directly to the public? : If you aren’t a WKSI ($700 million market cap), which doesn’t need SEC review of the registration statement, strategy to get issue out faster.

i. Out immediately, register the stock really quickly, and then they can be sold. Allows the issuer to be able to time the market and take advantage of a market window.

b. Does it matter what % of the common stock is acquired by the PIPE investors in the private issue?: If you issue enough stock to these private parties, we can say they are a control person, which has the effect of their sale of the stock being treated as a primary offering.

i. The SEC says 415 is for secondary offerings, for additional offerings of the common stock of a company that’s already issued public stock. Since this is a control person, in effect what we are looking at is a primary distribution of stock.

ii. Also, under a primary offering- you have Section 11 liability, whereas in a secondary offering you don’t.

1. SEC says if there is a sale of public stock by a control person, which could happen in a PIPEs transaction (stock issued in sufficient quantity), they aren’t allowed to take advantage of an existing shelf offering, require the company to register their shares again to protect the public as fully as they can

2. You can argue that you’re dealing with public companies that already have adequate disclosure and there’s no gain by re registering shares.

G. Exemptions - Transactions Not Involving an Issuer, UW, or Dealer: a. Ways that restricted security holders and control person can sell shares:

i. If holder of restricted security: Then 3 ways to avoid ’33 Act registration1. Wait until the securities come to rest2. Comply with Rule 144, the SEC’s safe harbor for secondary distributions3. Avoid a distribution and sell in a nonpublic transaction

ii. If control person and wish to sell without registration : Then 3 ways to avoid reg. 1. Claim that isolated and sporadic sales into public trading markets are not a

distribution (risky)2. Comply with SEC Rule 1443. Avoid using an UW by selling in a nonpublic transaction or selling directly

without assistancea. ALSO, could have issuer register the shares: Often covered by K, with

(1) piggyback rights (register next time files RS for other shares); (2) demand rights (register when holder wants registered, whether or not issuer want to be in registration and other shares being registered); (3) S-3 rights (once eligible to use S-3, register as S-3 offering)

b. The Broker’s Exemption and 4(4) : 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”

i. Distinguish “Brokers” from “Dealers” : 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.

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ii. Possible 4(3) or Rule 174 Exemption : 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.

1. Ex : a broker who sells to his customer registered securities of a reporting company is already exempt under Rule 174.

iii. Searching inquiry requirement : 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.

1. NOTE : 4(4) exemption protects ONLY the broker; the broker’s client must seek his own exemption for a resale.

c. Exemptions for Secondary Private Placements - The “4(1½) Exemption” (is resale by a control person a distribution?): Resale of securities originally purchase in a private transaction and then resold in another private transaction is not a “distribution” and does not trigger US status. Such resales are exempt under the 4(1 ½) exemption

i. What does 4(1 ½) mean : Describes 4(1) exemption in which there is no distribution, under the criteria for making a public offering under 4(2).

1. Shorthand expression for a 4(1) exemption when offers and sales are to nonpublic investors thus, no distribution, no UW, no registration, DONE

2. 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))

ii. When would this come into play : When control person can’t resell based on 144 (volume limit, issuer not current in reporting, or sale not via broker)

iii. When the 4(1 ½) exemption applies : Have to meet (somewhat relaxed) requirements of 4(2) for the resale to be exempt under 4(1)

1. Uncertain if sophistication is a requirement: One court says exemption applies when all 5 offerees mutual funds; Control person violated when sold after 4 years to person who had never invested before; Not rule as matter of law that someone with SLS degree and some investment experience met 4(1 ½) exemption

a. 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.

2. Broad solicitations are inconsistent with 4 (1 ½): EXCEPT permit public advertising of large block of stock provided that it will be sold to single purchaser

3. Number of purchasers must be small: should have small # and advise not to quickly resell so that shares wouldn’t soon be in hand of large number as would be the case in a public offering

4. Information disclosure requirement: General view that info requirement and advise seller to make current ’34 Act reports or information of the srot necessary to satisfy 4(2) or Reg D info requirements

5. Restricted nature : Securities sold under 4 (1 ½) are considered restricted (i.e., purchaser cannot resell without an exemption)

e. Secondary Distribution in Public Markets – Rule 144: Rule 144 serves as the Safe Harbor for Resales of Control and Restricted Securities. Most view 144 as exclusive means for control persons to sell into public trading market w/o registration

i. Purpose of Rule 144: Two main purposes of Rule 144

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1. (1) To let an affiliate (defined in 144a1) get rid of its restricted shares and resell them into the public market

2. (2) To let an initial purchaser of a private placement do the sameii. Effect of Rule 144: Gives you a safe haven from being called an underwriter, which is

the problem in resales (whether it is you or your broker being called an underwriter). If you comply with Rule 144, then neither you NOR your broker will be deemed to be an underwriter.

1. SEC says that “distribution” is the key concept in defining “underwriter”iii. What securities are covered by Rule 144

1. Restricted securities : Securities bought through non-public offerings or subject to Regulation D resale limitations (restricted securities)

a. Validity of private offering doesn’t matter for Rule 1442. Securities of control persons : Covers both restricted and unrestricted

securities of control personsiv. Act’s purpose and policy require focus on: (1) Disclosure, (2) Holding period to make

sure people buying under 4(2) exemption assume economic risks; (3) Market impact of transaction (4(1) applies only to routine trades, not distributions)

f. Substantive Provisions of Rule 144: i. 144b: Affiliate/control person/seller of restricted securities 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

1. What 144b means: The following activities are not “distributions” as long as all the Rule 144 conditions are met:

a. (1) Sales by non-control persons of restricted stockb. (2) Sales by control persons of restricted stockc. (3) Sales of control persons restricted stock

i. Remember: No distribution, no UW, and no transaction by UW, and no need for registration under the ’33 Act

ii. Conditions to be satisfied under 144 : Conditions vary upon (1) who is making the sale, and (2) whether the securities are restricted

1. Holding Periods (d) :a. Restricted Securities : 6 months for reporting company; one year for

non-reporting companyb. Non-restricted securities : No holding period for non-restricted

securities, including those held by control persons, e.g. registered shares

2. Current Information Requirement (c): Issuer must be subject to and current with periodic filing under the ’34 Act, or there must be otherwise publicly available information comparable to that found in such reports

a. Restricted securities : One year period for all restricted securitiesb. Control persons : Always for securities sold by control persons

3. Volume Requirement (e): a. Non-control persons: None for non-control personsb. Control persons: Always for securities sold by control persons (debt

and equity different)4. Limitations on Manner of Sale (f)

a. Non-control persons : None for non-control personsb. Control persons : Always for securities sold by control persons (through

brokers, market makers or riskless principal transactions)

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5. Notice to SEC Requirements (h) a. Non-control persons : None for non-control personsb. Control persons : Always for securities sold by control persons

6. Limitation on Amount of Sale : during previous three months amount of sale shall not exceed greater of:

a. 1% of class outstanding, orb. If traded on an exchange, avg. weekly volume on all such exchanges

within the preceding four weeks7. 144(e) sometimes requires aggregation of two or more sellers in determining

volume: When securities are sold by pledgees, trustees, estates; or when selling a convertible security and the security it’s convertible into

a. DON’T count - (see 144(e)(3)(vii)) : 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 : If you sell outside Rule 144, you’re on notice that you have a heavy burden of proof and cannot ask for a no-action letter

9. No More Change in Circumstances : This is NO LONGER RELEVANTiii. Important Definitions under Rule 144 :

1. “Restricted Security” – 144.a.3 a. 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 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 : Distribution occurs when investors unsophisticated b. 2—Volume definition in R. 144 : 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 RS2. Scott : informational advantage of CPs

v. 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 market2. Then can sell public stock short to lock in profit and repay broker with the

restricted stock at end of holding perioda. Policy : We don’t really care about holding periods when there is

already unrestricted public stock also tradingg. Rule 144A: Sales of restricted securities to QIBs by non-issuers

i. What is the point of 144A: Partially codifies 4(1 ½) exemption to facilitate trading in securities privately placed with institutional investors.

1. Opening of market with 144A to foreign companies: QIB carve out from S5 liability opens US Markets to foreign companies, less concern about lack of information with QIBs than with other buyers.

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a. This is more attractive with private placement BECAUSE issuers have easier access to more capital and have foreign companies raise capital in US Markets and more encouraged to do so in 144A when more liquidity since involves QIBs and no threaten to investor protection.

2. Impact of Rule 144A: Like Rule 144, the rule’s operative precept is that persons who satisfy its condition are deemed to not be engaged in a distribution and therefore not UWs, and any securities firms that serves as an intermediary is deemed neither a dealer nor an UW (144Ab, 144Ac).

3. Operational Provision 144A(b) : Sales by dealers or persons other than issuers, when compliant with 144A, are not distributions therefore the parties are not UWs therefore the exemption of §4(1) applies therefore §5 is not violated when resell without registering the securities

4. Creation of 144A Market: Securities cannot be traded on the public market (US securities exchange of NASDAQ), and rule contemplates creation of a private market in 144A securities

ii. What does 144A do : 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

1. Resale intent : Doesn’t matter if you purchase intended to resell2. BUT : (1) DOESN’T extend to publicly traded securities; (2) DOESN’T “cleanse”

shares of restrictions like 144iii. Why transaction not become a distribution

1. Step #1 - Sale from issuer to dealer under 144A viewed as private placement and transaction not involving public offering within the meaning of 4(2)

2. Step #2 - THEN dealer sells to QIB; could view that part (Dealer QIB) as transaction by dealer that is exempt from S5 based on 4(3) (dealer exemption)

3. Step #3 - THEN when QIB sells back to dealer, exempt under 4(1) since sale by someone other than issuer, UW, or dealer

4. RESULT : make market in 144A instruments without running afoul of S5iii. Conditions Necessary to Satsify 144A :

1. Seller : Cannot be an issuer; rule not intended to provide an exemption for primary distributions

2. Eligible purchaser – Qualified Institutional buyers: 144A’s guiding condition is that resales of unregistered privately placed securities must be to QIBs, defined as any institutions with at least $100M in securities. OFFERS and SALES only to QIBs

a. Banks and S&Ls : (1) Must invest in and own min. $100M in securities of institutions other than the bank/S&L in question; (2) 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

i. 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. (must be REASONABLE BELIEF that QIB)

3. Eligible Securities: Securities must be “non fungible”. Must be of a different class than those listed on exchange and NASDAQ since less disclosure and protection and don’t want getting into hands of public investors

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4. Defective Prior or Subsequent Sales Do Not Destroy 144A Exemption, Rule 144A(e): Exemption under 144A will not be affected by prior or subsequent x-actions by other sellers

5. Holding Period/Conditions on Resale: None6. Info : Basic financial info when issuer doesn’t file under ‘34 Act or furnish home

country info under Rule 12(g)(3-2)(b) (if reporting company, don’t need to furnish anything)

a. Type of info : Investor must be able to obtain—and be provided on request: (1) brief statement of business, and products and services offered; (2) most recent balance sheet; (3) profit and loss and retained earnings statements; (4) Similar statements for previous 2 fiscal years

i. Typical 144A placem’t begins w/offer memo incl. extensive disclosures & warranties

7. Seller must ensure buyer is aware seller may rely on 144A to avoid §5: Seller must take reasonable steps to notify the buyer that relying on 144A

8. Must be a Private sale: NO public sale permitted under 144A9. Liability :

a. Section 5 exception only : Provides exemption only from §5 of the ’33 Act; therefore, no liability under §11, §12(a)(1), §12(a)(2)

b. Antifraud liability remains: 10b5, state laws, other securities laws provisions

10. Non-integration (144A(e)) : Offers and sales of securities pursuant to 144A 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. Policy question - What could be done to make 144A more attractive?: (1) Less restrictive QIB definitions; (2) No info requirements; (3) Reduce liability (10b-5 still applies)

v. A/B Exchange Offers: Rule 144A has been used extensively in offerings of high yield debt to institutional shareholders, often followed by a registered exchange of the unregistered securities.

1. UW investigative burden: When restricted securities are exchanged for registered ones, exchanging security holders are named in registration statement as selling shareholders and thus have UW’s investigation burden

2. SEC No-Action Letters : Exchanging shareholder avoids UW status if not otherwise a broker engaged in the distribution of a security (A/B exchanges)

3. Limitations : SEC limits its position to nonconvertible debt, certain preferred stock, and foreign issuers’ initial U.S. offerings

4. Application to US Issuers : Not available to U.S. issuers of common shares whereby restricted security is exchanged for a registered on

5. When A/B exchange occurs : Occur increasingly around 144A, w/ institutional buyers obtaining agreement from issuer to exchange at a later date the registered for the unregistered securities.

Chapter 10 – Financial reporting

A. Public Company Disclosure Requirements, pp. 545-54, 564-69, Problems 10-3 a. Regulation of Public Companies under the ’34 Act (Exchange Act) : Exchange Act extends the

disclosure regime for public offerings to public trading of securities. Companies whose shares

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are publicly traded must register with the SEC, which makes them subject to the following ’34 Act requirements

i. Filing periodic disclosure documents : Filing of these documents makes them available to securities trading markets

ii. Keep records and maintain a system of internal accounting controls : To carry out reporting requirements, the reporting company must keep records/have internal controls in place for accounting

1. ALSO : tender offer disclosures and disclose insider trading (not as relevant for the purposes of this class)

b. PURPOSE of periodic reporting in Exchange Act : More informed trading decisions (same as with more informed purchasing decisions with ’33 Act). Minimizes/makes difficult for fraud because if have reliable periodic reports, makes kind of manipulations more difficult

i. Generally speaking : Require reporting under the ’34 Act to facilitate investment decisions (rationalized allocation of capital) AND discourage manipulative activities

c. When are the registration requirements triggered under the ’34 Act : Two triggers that compel a company to register with the SEC and subject to ’34 Act regulation

i. Listing on an exchange – S12 : Companies who securities (debt or equity) are listed on a stock exchange are compelled to register with the exchange, with copies to the SEC.

ii. Meeting size requirements : Company must register if it has a class of equity securities held by more than 500 shareholders and has total assets exceeding $10M (registration must occur w/in 120 days after fiscal year in which it crosses both thresholds)

iii. Public issuers – 15d : Reporting requirements apply to any company that has issued securities (debt or equity) in an offering registered under ’33 Act even though the securities are not listed on a stock exchange and company does not satisfy the size thresholds of ’34 Act. Must begin reporting once RS effective and can cease only if at beginning of fiscal year has less than 300 record holders of class of registered securities

d. When can deregister : (1) Voluntary/involuntary delisting; (2) Fewer than 300 equity shareholders OR combination of fewer than 500 equity shareholders and less than $10M in assets for last three fiscal years

e. Exemptions from registration : securities of investment companies, securities of savings and loan companies, securities of nonprofit organizations

f. Periodic disclosures required under ’34 Act : If reporting company, must make (1) filings to keep registration current and (2) filings of annual, quarterly, and special reports

i. Annual reports – 10K : Reporting companies must file annually extensive diclsoure doc that contains much the same information as required in ’33 Act when a company goes public (akin to RS for S5 in ’33 Act) (filed 90 days from close of fiscal year)

ii. Quarterly Report – 10Q : Must file within 45 days of close of each of the three reporting quarters a report that consists mostly of quarterly financial statements

iii. Special reports – 8K : Must file w/in 4 days of event a special report on specific material developments

1. Events that must be reported under 8k : (1) Operations events, (2) financial events, (3) securities related events, (4) financial integrity events, (5) governance events

2. Result of 8k (workhorse of ’34 Act) reporting requirements : System of continuous reporting nearly in place, expectation of disclosure, and when don’t have disclosure, investors will not be willing to invest and will discount securities accordingly; Culture that penalizes failure to make continuous disclosure

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3. Must look to Regulation S-K : S-K determines how to fill out these forms and make mandatory periodic disclosure

g. Certification of SEC filings : Under SOX, corporate officers of reporting companies must certify that annual and quarterly reports that are filed with the SEC.

i. Certification requirements : CEO and CFO must certify that he reviewerd the report and based on his knowledge, that (1) does not contain any material statements that are false or misleading, and (2) it fairly presents the financial condition and results of the operation of the company.

1. Controls : Also must certify that responsible for establishing and maintaining “disclosure controls and procedures” that ensure material information is made known to them, and that these internal controls were evaluated before making the report. If any deficiencies/changes internal controls/fraud, certifying officers must disclose to auditors and board’s audit committee

H. FINANCIAL REPORTING AND FINANCIAL STATEMENTS a. Who uses FS?: investors, analysts, regulators, tax authorities, competitors, suppliers, creditors,

the management of the company itself (beyond scope of buying and selling securities) b. Common metric with accounting : GAAP, general accepted accounting principles, established

by the FASB (financial accounting standards board)i. FASB : Self regulating organization, private body that governs itself subject to SEC

oversight; funded through registration fees of public companies (after SOX) c. Role of SEC with GAAP : does have the ability to come up with accounting standards to be

used (13b1, 1934 Act), empowers SEC to establish rules and methods for financial documents filed with the SEC

i. Regulation G : regulating pro forma presentations, possible to paint more promising financial picture, problem where management cherrypicks what it puts into the pro forma representation

1. Provide financial condition of entity (created by accountants to convey to shareholders what combined entity would look like and whether consideration receiving commensurate with the value created by the transaction)

d. Role of the auditor : Certify with opinion letter that reviewed FSs, and with GAAS and fairly present the financial position of the corporation

i. Why need 2 nd layer of review: minimize bias, independent second look, generate confidence in the accuracy of the financial statements, privatize what could be otherwise expensive gov’t function, ALSO there is not one set way of doing accounting and reasonable people can differ

ii. GAAP: now determined by Public Company Accounting Oversight Board (PCABO), established by SOX, see Free Enterprise Fund case (SCOTUS and constitutionality of PCABO)

e. Why need independent auditors : Didn’t want cross selling services, problem with financial dependence of auditor on person who is auditing

f. Private Actions to compel Honesty in Mandated Reports i. Section 18: (1) Eyeball reliance: have to see statement that complaining about; (2)

Defenses: good faith affirmative defense, carries burden of proof to show good faithii. Section 10 (see rule 10b5) : No eyeball Reliance if 10b5 claim based on the fraud on

the market theory; plaintiff can bring case w/o having seen statement if P can show that securities traded in efficient market; loss cause, P has to allege facts showing that D “intended” to defraud or “reckless” as to the truth

e. Book and records requirements of Exchange Act

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i. See 13b2 : ’34 Act Reporting Companies must keep accurate books and records and maintain reasonable internal accounting controls.

1. Must maintain financial records in “reasonable detail” and put into place internal accounting controls sufficient to provide “reasonable assurances” of internal accountability and proper accounting

ii. See 13b7: Terms "reasonable assurances" and "reasonable detail" mean such level of detail and degree of assurance as would satisfy prudent officials in the conduct of their own affairs. type of negligence standard

iii. See 13b4/5 : No criminal liability except as provided in p5 and no person shall “knowingly” fail to do anything related to books and records (see FCPA of 1978)

iv. Problems meant to address : (1) Slush fund problems; (2) Checks and balances w/in system that make sure assets under appropriate custodianship and inventory control

I. Financial Reporting and The Sarbanes-Oxley Act a. 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 1935b. Audit Requirements, ’34 Act, §10A (CS 615) .

i. 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)

ii. Prohibiting various types of non-audit services (§10A(g), CS 617)iii. Requires Audit Comm. approval and disclosure for other non-audit services, 10A(h)iv. 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)v. Audit firm shall report particular data to Audit Committee, 10A(k)

vi. Audit firm is selected and employed by the audit committeevii. Non-compliance delisting

viii. Audit committee has $$ to pay audit firm or other advisers, 10A(m)ix. Need to establish ombuds process for complaints and whistleblowersx. 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)

c. Loans to executive officers and directors : Prohibitedd. Disgorgement of : CEO and CFO compensation following restatement of financial statementse. CEO and CFO certifications of financial statements- (404) : For each periodic report must

certify (1) review rpt, (2) to their knowledge, the report contains no untrue stmt of material fact; (3) to their knowledge, the report fairly presents the financial condition and results of operations; (4) 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

f. Independence of the Audit Comm. , S-Ox §301 (§10A(m) of ’34 Act, CS 618), §407 g. Independent directors only : may not be an “affiliated” person of the issuer or accept any

consulting, advisory, or other compensatory fee from the issueri. 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

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ii. 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

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

i. Outside Advisers : Power to retain, eg. law firm, & compel funding, §10A(m)(5)-(6)m j. 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 1959i. 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.

ii. 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))

k. Pro-Forma Financials - Reg G : Whenever pro-forma financials are issued, issuer must provide a comparison/reconciliation to the GAAP financial statements

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

J. Management Discussion Analysis, Item 303 of regulation S-K: Calls on mgmt to provide narrative explanations of the financial statements for the purpose of increasing the transparency of a company’s financial performance and providing overall better disclosure to investors.

a. Requirement: Must disclose trends and rsisk that have shaped the past and are “reasonably likely” to have on impact on the future long-term and short-term liquidity, and capital resources, as well as discussing the performance of diff. segments of the firm’s business and its critical accounting policies

b. Accounting: Must provide penetrating analysis of the accounting policies and of how the bottom line is sensitive to these estimates and judgments

c. No Merger disclosure: Merger negotiations needs not be disclosed in MD&A if company believes the disclosure could jeopardize completion of the acquisition

d. Why MD&A Matters : Bears on materiality/liability o Case Law with MD&A Disclosures in Continuous Reporting Disclosures - In the Matter of

Caterpillar (p. 576, SEC proceeding): Disclosure of extent of contribution required under Item 303 (since contributing 23% to profit and ability to make contributions based on one time events that would not occur again)

i. Item 303a3ii : Requires the registrant to disclosure any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenue or income from continuing operation

ii. Problem with approach : Cannot take wait and see approach and have to aleter market to known uncertainty that would have impact on operations

iii. Speculation and liability – Rule 175 Safe Habror : Statements not fraudulent unless made without reasonable basis and made in good faith. If MD&A has reasonable basis and made in good faith, then no fraud liability (Rule 175 deals with SEC filings, safe harbor deals with broader category of statements that creates defense to liability in private action)

1. No 10b5 under Item 303 : Item 303 does not provide the basis for a duty to disclose pessimistic internal forescast so that a private recovery can occur under 10b5 of ’34 Act.

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Chapter 3 – Markets and Their Efficiencies

A. Markets and Investors, pp. 93-103: a. Structure of the Trading Markets: Exchanges (NYSE) OTCs (shares not listed), ENCs (comps

that match auto. Customer limit orders), regional exchanges (other than NYSE and NASDAQ), block trading (10K+ shares b/w institutional investors w/o broker/dealer), EBBs (only for ’34 Act reporting companies), pink sheet market (residual trading market), Bond market (almost totally dealer markets, instrument of choice for corporate issuers))

b. Globalization of the market: Faster capital formation ww with technology, US company ownership more widely dispersed (not so in other countries with family/state control this means that harder to take action with US company since wide ownership, corporate governance, etc.), interconnectedness of markets means that economic events have worldwide repercussions

c. Institutionalization: Institutions hold over 60% of securities (less emphasis on individual securities owners) based on social, politicial and economic forces

d. Derivative markets: entire markets for financial instruments whose value depends on the price of some underlying instrument (eg, stock option, futures); Policy problem in that compete with the capital markets and drain liquidity from the equity markets, and problem with OTC derivatives which receive no regulation

B. Policy Considerations about Markets and their Efficiencies: a. #1 - What is implication of numerous market and market makers on price discovery

information? What are implications of multiple markets for discovering best price and lowest transaction costs?

i. Multiple markets + LINKED markets = better price discovery1. Better linkage = lower transactions costs = more efficiency (larger network,

more connection = fewer arbitrage opps)ii. Multiple markets + DISCRETE markets = greater inefficiency, opp for arbitrage profits

(trader make profit by trading when buy lower in A and then sell lower in B); also more transaction costs associated in discrete market

b. #2 - What are the regulatory challenges posed in the United States by the globalization of securities markets?: Protect US Investors dealing with foreign issuers in US markets or markets abroad by not establishing rules that are more onerous than those in home countries (want markets as efficient and broad as possible so that prices set at most efficiently)

c. #3 – What is the impact of Institutional Investors on the market (see p. 100): More sophistication = transactions costs lower based on scale economies, maybe need less disclosure). If holders of stock more sophisticated and lower transactions costs, therefore overall market more efficient (market more efficient by institutionalization), thus regulatory implications that SEC need not be as concerned about mandating disclosure in way that might be if market was comprised predominantly of individuals who lack sophistications of institutions

i. Maybe should regulate institutions heavier, rather than mandate more disclosure from securities laws

C. EFFICIENT CAPITAL MARKET HYPOTHESIS (ECMH) a. What want to answer? : Want to figure out what explains changes in securities prices

i. Weak ECMH : Market incorporates all information based on past security prices. Doesn’t depend on disclosure, just on history of stock prices

1. How works : Explain with past changes in securities prices (largely rejected)

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2. If market liquid and information readily available, price changes will not be correlated with past price changes (randomness of stock prices)

ii. Semi-strong ECMH (Prevailing view) : Market incorporates all public information. Once you make disclosures it will have adjusted because it will have become public information and that means its too late.

1. How works : Stock prices changes based on material information about the issuer (from any source); that explains changes in stock prices; ECMH testing has somewhat validated SS ECMH, if efficient market, can show correlation with changes in available information and prices

iii. Strong ECMH : Market incorporates all info, incl. any opinions about the info. No matter what you do about mandatory disclosure, the market would ferret it out anyway and the mandated disclosure won’t make any difference.

1. How it works : Market prices reflect all material info, whether or not it is public (assume that people with inside information are trading). Largely not true

2. Consider : Don’t need little guys doing right thing with publicly available info. Sophisticated buyers/sellers digest info and move the market. Individual investors aren’t moving the market (they’re too late).

b. Criteria for trading in an efficient market : See 5 factor test in Cammer v. Bloom (DNJ, 1989)i. Five factors: (1) Percentage of shares traded weekly; (2) analysts following, (3)

percentage of market makers and arbitrageurs, (4) eligibility to take advantage of Sec integrated disclosure via Form S-3 for engaging in public offerings, (5) responsiveness of security’s price to new information

c. What doesn’t ECMH explain? i. Noise on the market : Investors don’t always act rationally, small changes in the

fundamentals of company can stimulate strong stock market reactions with price changes or buying changes

ii. Informational efficiency : Market responds quickly to information, but not necessarily fundamentally efficient since change in price not related to intrinsic change in value of the company

1. Policy choice : How much do we care whether markets fundamentally efficient vs. informationally efficient?

a. CONSIDER : Point of securities laws is to require disclosure of material information or penalize provision of false information. Whether or not price changes fundamentally/info efficient won’t matter

d. Behavioral Finance Research : Here is what we know about behavioral tendencies and investing: (1) Loss aversion: People aren’t entirely rational (they hold onto losing stocks too long and sell winning stocks too early); (2) Cognitive conservatism: people change their views slowly even in the face of persuasive evidence; (3) Overreaction to new information: market sank 777 points because the bailout bill failed; (4) Herd influence; (5) Overconfidence

Chapter 11 – Inquires into the Materiality of Information

Does disclosure have to relate the import of the disclosed facts (see Merck, p. 589) issuer or person making statement doesn’t have to quantify/explain impact of the disclosure on the company don’t treat shareholders liker children, tell facts and they can draw own conclusions as to implications

Questions about wether subsequent reports (rather than initial disclosure) was what impacted stock price court will look at impact of 1st announcement and if it didn’t move the market price, will not be viewed as having revelaed anything that was previously untrue

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Materiality reliance causation are all related concepts, arguments made separately but are related and aspects of the same thing all comes down to causation

Market Reaction and how that affects materiality: If have statement that made by C1 and announce something that P would say reveals that prior

statement untrue (eg, restatement of financial statement, ack. That original statements false)o Assume that stock price doesn’t move day of announcemento Further assume that traded in efficient marketo Does this mean that statement not material? in some sense causation and materiality

related, but asking whether fact that disclosed and has no impact on the market price would be material in Northway test, assuming actual significance to reasonable shareholder or having altered total mix of information

Burlington, CA3 say no impact, then no materialty (as ECMH says if material, there will be impact)

TRUTH not quite so simple since many things can impact stock price Event study, run regression against index, need to view against the whole

market and how much stock price dropsALSO, consider stock price overreaction (announcement causes stock to drop too much, how much can P’s recover_ calls into question ability of mgmt, now risk more significant, and risk comes from lack of confidence in mgmt (D would say nothing attributable to actual announcement and has to do with something else and wouldn’t be liable)

A. Materiality Generally :a. Problem that materiality seeks to address with mandatory disclosures : If insufficient

information, investors shy away from investing. If too much information required and disclosure becomes too costly, business avoid financing through securities and securities market wither. Thus materiality seeks to avert informational scarcity and overload.

i. Policy choice : Materiality test takes into account costs and burdens of providing information as well as benefit that information would have to the investor (balance costs and benefits of disclosure)

b. Where Materiality Applies :i. Disclosures : In addition to line item disclosures, the items of information required in

SEC filings reflect on what investors consider material. SEC rules require that filings contain “such further material information . . . as may be necessary to make the required statements . . . not misleading”

1. NOTE : applies to both ’33 and ’34 Actii. Antifraud Liability : Many antifraud rules in the securities laws hinge on materiality

(10b5 liability attaches when make “any untrue statement of a material fact” or omit “a material fact necessary in order to make the statements . . . not misleading”)

c. What to consider with materiality: Depends on (1) the costs the disclosures add to business transactions, (2) availability of same information through unregulated channels, and (3) effect disclosure has on substantive regulation in other areas

B. Material Orthodoxy: a. Definition of materiality – Substantial Likelihood Test: A fact is material if “there is a

substantial likelihood a reasonable investor would consider it important” in making a securities-related decision. There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information available.

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i. Substantial likelihood : Info probably would have been important to the reasonable investor, not that it is importance is “merely possible”

ii. Causation not required : Not a “but for” test, but rather it is enough that the information would have assumed actual significance in the investors’ deliberations

iii. When would apply test : Disclosure involving shareholder voting, securities trading, a tender offer, or itemized disclosure in securities filing

iv. Question of law/fact w/ materiality : mixed question of law and fact when determining “materiality”

v. Policy considerations with flexible test : Imprecise, difficult to apply, consequence is uncertainty with disclosures, disclosure process more complicated, BUT can be good to preserve discretion for judges and regulators to apply facts to specific case

1. Problems with bright line test : If have bright line test, can fall within letter of rule and have savvy persons evade the law (general theme in securities law)

vi. 3 main issues with substantial likelihood test : (1) what is “substantial likelihood”; (2) who is a reasonable investor; (3) what is the “total mix” of information

b. The Reasonable Investor Standard : 2 competing standards usedi. Main issue : Is purpose of securities laws to protect unsophisticated investors,

sophisticated securities analysts, or both groups?1. Professional standard : Measure materiality of information against what a

professional analyst would consider price sensitive (Wielgos) 2. Average investor : congressional intent to protect the “average small”

unsophisticated investorc. Materiality and quantitative standard : Rule of thumb used to be that misstatement regarding

a financial statement item of 5% or less was not material, but SEC Staff Bulletin No. 99 rejects this approach as too limited in scope:

i. No quantitative test – must look to total mix of information : Lawyers and accountants must assess an item in light of the total mix of information, so that a change of less than 5% could material if, for example, it masked a changes in sales or earnings trends, changed a loss into income (or vice versa), hides a factor to meet analysts’ expectations, or concerns a segment of issuer’s business that has been identified as playing significant role in operations.

1. Won’t necessarily excuse intention small mistakes : Can’t make intentional errors in financial reporting by stating that just a small amount of mistake. Will look at motivation and surrounding circumstances.

ii. Subjective test (small # of shareholders or F2F): See Thomas v. Duralite, Objective standard appropriate when lg # of shareholders, but when dealings on face to face basis (single buyer and seller),distinction b/w objective materiality and subjective reliance becomes obscured

1. Mostly used as a bar in actions where reliance deemed to be unreasonable and thus doesn’t meet reasonable investor standard (blur line w/ materiality and reliance/reasonableness of investor)

d. Relationship b/w Materiality and duty to Disclose : False/misleading info is not material, and not all material information must be disclosed. Duty relates to whether and when information must be disclosed; materiality relates to what information must be disclosed.

i. Do not confuse materiality with duty to disclose : Consider idea of duty to disclose separate from whether fact/thing/forecast/opinion is material

ii. First question – is there a duty to disclose? : Unless there is a duty to disclose, the materiality of the information is unimportant. Duty to disclose arises in two situations:

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1. SEC Filing Obligations: Companies offering securities to the public and reporting companies must provide line item disclosures in SEC filings, such as RS and periodic reports by reporting companies.

a. Policy judgment: Certain info not “per se” material but on average regulators think that investors should have this information.

b. No misleading info : If relying on letter of rule is to disclose is to make statement that misleading, CANNOT do this.

c. Additional info : SEC requires companies to including in their filings any other material information to make line-item disclosure not misleading. (Rule 408/12b-20)

2. Duty of honesty : Antifraud provisions of federal securities laws require complete honesty concerning material information whenever one speaks in connection with certain securities transactions – trading, voting, and tender offers for publicly traded shares.

a. What this encompasses : Companies must (1) not make materially false statements, (2) not make materially misleading statements, (3) correct materially false/misleading statements, and (4) update statements that have become materially false or misleading

b. No duty = doesn’t matter is material : If the company does not speak and has no specific duty to speak, the federal securities laws permit mgmt to keep business information confidential, no matter how material.

i. BUT : If speak when don’t have duty, companies have a duty to disclose all material facts necessary to make not misleading

c. NOTE : When think about duty to disclose, must think about what MUST disclose, which leads to discussion about materiality

C. Materiality and Types of Information : SEC and courts take different approaches to materiality depending on the type of information

a. Historical information: Most disclosure is based on verifiable information, such as past financial results, completed business transactions, executive compensation, and shareholdings

i. Test that apply if historical information: Substantial likelihood frames the inquiry1. Change in stock price: If disclosure of past information coincides with

abnormal change in public stock prices, courts assume that information was material since affected

2. No price change: Sometimes if price doesn’t change, will still be material information when information had been absorbed into the market prior to disclosure (eg, confirmation of false rumors can be materially misleading)

3. No objective test: Rejection that 5% is benchmark for materiality (eg, 2% could be misleading when did it to meet analysts projections)

4. Off-balance sheet disclosures: Reporting companies must disclose off-balance sheet arrangements and known contractual obligations reasonably likely to have a material effect on the company’s financial condition in the MD&A of the company’s disclosure documents (SOX 401, Item 303c, Regulation S-K)

b. Speculative Information : When info relevant because portends future event (eg, negotiations that could lead to a merger or exploratory drilling that might lead to mining bonanza) courts have applied special version of “substantial likelihood test”

i. Test – Probabilities test : Materiality will depend on balancing 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 (Basic)

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1. How the probabilities test works : Measures the current value of info that bears on a future event by measuring the financial significance of the event, discounted by the chances of it actually happening.

a. Discounting : Information is material if its expected value (discounted by its uncertainty) indicates it would affect investor behavior

b. Timing of disclosure – statistical significance: Need for statistical significance (drug companies not required to disclose isolated illnesses until statistical significance to show that drugs caused illness and serious enough to affect future earnings) (Carter Wallace)

i. Pending at SCOTUS – Matrixx : Issue whether a plaintiff can state a claim under § 10(b) of the Securities Exchange Act and SEC Rule 10b-5 based on a pharmaceutical company’s nondisclosure of “adverse event” reports even though the reports are not alleged to be statistically significant.

1. P argument : Duty to disclose since when talked generally about products should have disclosed that litigation ongoing.

2. D argument: Wants bright line test, relied on Carter Wallace, says that in pharma until adverse effects shown to be caused to statistical significance, no duty to disclose

3. CA9 : Rejected Carter Wallace, says no bright line test4. Consider : P can concede statistical insignificance but

would be material (actual significance to reasonable shareholder) because from reasonable investor standpoint, prospect of litigation over product that constitutes significant amount of revenues and potential for FDA investigation significant. Even if small probability that would occur and product withdrawn, consequence to company of that happening so great that Basic should apply and bright line test inappropriate

c. Rejection of bright line “price and structure” test : Basic moved away from bright line test that merger agreements deemed material only when the parties had agreed on price and structure of the transaction

i. Rationale : Denying investors info about possible merger assumed investors could not discount the uncertainties of merger negotiations (even if material) need to be disclosed.

ii. NOTE : Companies do not need to disclose sensitive merger negotiations, even if material, as companies can remain silent as long as they do not release false or misleading information. But if make affirmative false statement, duty to disclose arise

ii. Puffery : Overstatement of present circumstances based on a hope that events turn out well. Courts have been reluctant to treat optimistic statements as misleading under common law notion that puffery not actionable

1. Hindsight bias : Prevalent with whether puffery applies, easy to say didn’t mean when consequences are not serious

2. Smooth selling process : Everyone knows that someone trying to sell something going to speak on the bright side when company put itself up for sale and represented that auction process going smoothly (Eisenstadt)

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c. Soft information : Information that looks into the future and makes projections, estimates, or opinions is called “soft information”, it is both valuable and perilous for investors since relevant to investors, but companies have incentive to mold predictions

i. Voluntary disclosure of forward looking information: SEC permits forward looking information unless the statement was made “without a reasonable basis” or disclosed “other than in good faith” (175/3b-6)

1. Subjective test: Focuses on what mgmt knows/should know when it looks to the future

ii. Mandatory disclosure of forward looking information: SEC requires presentation of soft information in MD&A of certain filings, such as annual reports and prospectuses. Must describe trends and uncertainties that are “reasonably likely to result” in material changes to the company’ financial position.

1. Rationale: Present picture of company’s financial position through eyes of mgmt when historical data not a good indicator of future results

2. Liability for omissions: Court hesitant to impose liability for omitted soft information, such as internal appraisals or financial projections that would seem highly material.

a. Test: Courts have not required forward looking information when it is unreliable, uncertain, or based on speculative assumptions

i. Rationale: Concerns about competitive costs of managers revealing business secrets

iii. Actionability of forward looking statements: Limited actionability of forward looking statements and soft information

D. Materiality in context – “Total Mix of Information”: Disclosure is contextual, info revealed in one part of document may be tempered in another part, or an important piece of information omitted from SEC filing may already be widely known by investors.

a. Total mix test: There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.

i. What this means: Omission is not material (even if info important to investors) if reasonable investors can infer the omitted information from other disclosures.

b. Total mix and efficient market : Omitted information that is already known to the market is not actionable. Some courts assume the market is informed to avoid analyzing whether information is material or inquiring into management’s integrity.

i. Ex : When labor violations reported in press, assumed market aware even though came from union and denied by company (Food lion);

ii. Truth on the market : False or misleading disclosure on important company matters not material if professional securities traders who set market price know the disclosure to be wrong. Managers can lie if the market knows their dealing with liars.

c. Buried facts doctrine : Disclosure can be misleading if it contains information that is inaccessible or difficult to assemble (Kohn).

i. Curing : But if company discloses both accurate and inaccurate information, court will consider whether the document as a whole is misleading, as accurate specific disclosures can “cure” inaccurate general disclosures

1. BUT : Truth does not neutralize falsity if the truth is hidden or discernible only by sophisticated investors.

ii. Arguments against buried facts doctrine: (1) D says no omission since disclosed and discharged duty; (2) If reliance element of claim, unreasonable for plaintiff to rely on the misrepresentation that allege if it is buried fact; (3) Truth on the market

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1. Truth on the Market defense : If efficient market, all information taken into account of the stock price. D can argue that ECMH incorporates information into the pricing, could not be any misleading information. Plaintiff may not have seen buried fact, but doesn’t mean that market didn’t. If sue on fraud on the market, saying the efficient market, and thus plaintiff cannot recover since this is an efficient market

iii. Role of prominence of the disclosure : Whether total mix of information impacted by buried fact (mix in case law whether information must be in SEC filing/newspaper article). Fact based analysis in which many things must be considered.

1. Relation to materiality : Buried fact then related to MATERIALITY since question whether fact that omitted nevertheless presented in a way that would affect the total mix of information available to investors and considered for purposes of materiality under the Basic test.

E. Safe Harbor for Forward Looking Statements : Cautioning statements that identify risks temper forward looking statements and sometimes render the statements immaterial.

a. Bespeaks caution doctrine : Cautionary disclosure beyond boilerplate language/warnings can negate the materiality of, or reliance on, an unduly optimistic prediction.

i. Test : When an offering document forecasts, opinions, or projections are accompanied by meaningful cautionary language, the forward looking statements will not form basis of fraud claim if those statement did not affect the total mix of information provided to investors. Cautionary language, if sufficient, renders alleged omissions or misrepresentations immaterial as a matter of law.

1. What is meaningful cautionary language: Turns on the facts of the case, usually turns on whether specific vs. general language

2. Trump case : Hopeful statements in prospectus that operations will be sufficient to cover debt service were rendered immaterial by extensive cautionary language elsewhere in the prospectus, including numerous disclosures in prospectus of circumstances that could affect issuer’s ability to pay interest, which alerted to the risks of the venture (Kaufman)

3. Puffery as potential defense : Before a forward looking statement is material, it must give rise to the level of a guarantee (numerous circuits)

4. Shift – main issue whether historical vs. forward looking: If historical fact, bespeaks caution DOES NOT apply. If forward looking, doctrine DOES apply

b. PLSRA Safe Harbor : To encourage issuers to disclose forward looking information, PSLRA immunizes public companies and their executive from civil liability (not administrative) for forward looking statements that comply with the Act’s safe harbor provisions. There are 3 separate safe harbors:

i. No actual knowledge : Immunizes reckless/negligent forward looking statements, and no liability unless statement made with actual knowledge that false.

ii. Immateriality : No liability if forward looking statement is immaterial, focuses on whether forward looking statement is too “soft” to be material (then can use “bespeaks caution” doctrine as separate basis for immunity

iii. Cautionary statement : No liability if forward looking statement is identified as a forward looking statement and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in the forward looking statement. (can dismiss suit w/o materiality or knowledge inquiry)

1. No boilerplate : Boilerplate cautions not enough. Cautionary statements must convey substantive info about factors that could realistically cause results to

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differ materially from those projected in forward looking statement and must be relevant to the projection.

iv. What statements does PSLRA safe harbor apply to : (1) Projections of revenues/other finances; (2) plans or objectives for future operations; (3) statements of future economic performance including MD&A statements of financial condition and results of operation; (4) assumptions underlying these statements.

v. Limitations on PSLRA safe harbors : Only apply to SEC reporting corporations (not partnerships/LLPs). Do not apply to IPOs/tender offers/going private transactions.

vi. Main issue with PSLRA safe harbor : Is this forward looking statement or is it present/historical facts? Is there meaningful cautionary language?

1. Clear prediction : Statements generally must have clear predictive quality. Language like “believe” or “anticipate” make it forward looking.

2. Cautionary language : CL in prior SEC filings insignificant. Inconsistency with specific/general warnings and what necessary.

Safe Harbor Coverage Conditions ConsiderSEC (175/3b-6) Forward looking

statements by issuer in SEC filings

Statement not fraudulent, unless shown to be w/o reasonable basis or other than in good faith (not necessary to ID risk factors)

Judicial (bespeaks caution) Forward looking statement by any person, whether or not in SEC filings

Statement not material (or presume no reliance) if statement cautions and generally describes possible risk factors

Broader than SEC/statutory safe harbors.

Covers nonissuers and applies whether or not FLS in writing or filed with the SEC

Focus on objective disclosure made by issuer than on mgmt subjective intent (reasonable basis and good faith)

Statutory (cautionary language)

Forward looking statement by issuer in specified SEC filings

No private liability, if statement ID’s as forward looking and accompanied by meaningful cautionary language that IDs risk factors

Focus on objective disclosure made by issuer than on mgmt subjective intent (reasonable basis and good faith)

Liability Under the Securities Act (’33 Act)

A. Overview of Liability Under the Securities Act :a. Statutory provisions that we care about :

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i. S11 - liability related to fraudulent RS: If RS (including prospectus) contains materially false or misleading statement, purchasers in registered offering can recover damages from specified participants in the offering

ii. S12a1 (liability related to noncompliance with registration rules): If seller/offeror violates registration or gun jumping requirements of S45, securities purchasers can rescind their purchases

iii. S12a2 (liability for fraud in a registered offering): If sales/offers in registered offering (not subject to S11 liability) are accomplished by means of materially false or misleading information, purchasers can rescind their investment

iv. S15 (control person liability): Investor can recover on joint and several basis from persons (whether individual or corporate) who control any persons liable under S11 or S12.

v. S17 (government civil enforcement authority for offering accomplished by false/misleading): SEC has broad authority over offerings (registered or not) accomplished by false or misleading means

vi. S20 (SEC civil injunctions and penalties for violations of ’33 Act or rules): SEC can seek civil injunctions and penalties in court for violations of the Securities Act or its rules. Can also issue cease and desist orders under 8A.

B. Section 11 Liability under the ’33 Act/Securities Act a. Statutory provisions that we care about : §11(a): Liability & Liable Persons; §11(b): Defenses;

§11(e): Damagesb. What is the purpose of S11: Creates a civil remedy for purchasers in a registered offering if

they can point to a material misrepresentation in the registration statements. Joint and several liability falls on the issuer and other specified defendants associated with the distribution, subject to nonculpability (“due diligence”) defenses for nonissuer defendants and a special rule of proportionate liability for unwitting outside directors.

i. Materiality: Look to definition under ’33 Act (could be financial problems that require a restatement); Forward looking statements have safe harbors if (1) lack of actual knowledge of falsity ; (2) immaterial; (3) accompanied with meaningful cautionary language; also SEC safe harbor for SEC filings and “bespeaks caution” doctrine

c. Section 11a statutory language: (1) If any part of a RS, when such part became effective, (2) contained an untrue statement of a material fact, (3) or omitted to state a material fact required to be stated therein (MMO) or necessary to make the statement therein not misleading, (4) any person acquiring such security can sue [can sue issuer, even if purchased in the aftermarket] (5) unless he knew of the MMO at the time of acquisition

d. Who can serve as plaintiffs under 11a : Applies to private parties – any purchaser of registered securities has standing to sue.

i. Initial distribution vs. aftermarket : Some courts limit recovery to only those plaintiffs who purchased in the original distribution; other courts extend S11 standing to those who acquired registered securities in the postoffering aftermarket.

1. See Hertzberg v. Dignity Partners, CA9 (§12: seller is liable “to the person purchasing such security from him” Implies privity reqm’t;§11 only says “any person purchasing such security.” Implies P can sue issuer, even if purchased in aftermarket if can show securities associated with defective RS)

ii. No privity requirement : §11(a) does not require privity between the issuer and the purchaser in a transaction (purchasers in the secondary market are eligible plaintiffs)

iii. Tracing Problem and Requirement : If shares can’t be traced to that specific RS, then no §11 standing.

1. When can trace : If plaintiff purchased directly from UW or dealer selling its allotment, then tracing is possible.

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2. When cannot trace : If plaintiff purchases in the aftermarket, then tracing becomes problematic for a S11 plaintiff.

a. Note : Big companies have many RSs, so any purchase made in the aftermarket cannot be traced to the specific RS

iv. Only actual purchasers : S11 standing limited to actual purchasers. If relied on RS but did not purchase, then no standing. No standing if (1) relied on misrepresentations to trade in other securities of the issuer, or (2) nonpurchasers who rely to their detriment on false statements. See Barnes v. Osofsky, CA2

v. Plaintiffs need not show reliance : Need not show reliance unless bought 1+ yrs after RS effective date and 12 months financials were issued

e. Section 11 Defendants : i. Potential defendants : Potential defendants include four categories of individuals

1. Individuals who signed the RS : issuer and CEO, CFO, and accounting officers2. All the directors at the time of the filing : Can be D’s whether or not they

signed the RS3. The Underwriters of the offering : Self explanatory class4. Any expert who consents to his opinion being used in the RS : Can include

accounting firm that audited company’s financial statements; liability limited to information prepared and certified by him

ii. Liability :1. Liability generally : joint and several liability EXCEPT (1) UW liability limited to

the amount of participation in the offering and (2) outside director liability proportionate to the damage they cause unless knowing violation committed

a. Control persons : J&SL on Controlling persons of Section 11 Defs – SA §15. If control a liable party, liable unless no knowledge of/no reasonable ground to believe the party was liable (e.g., holding company that owns the UWs)

b. Issuer liability : strict liability no diligence defenses, plaintiffs’ knowledge, reliance, causation not req’d , misstatement is all that matters, regardless of what the issuer knew

c. Underwriters : Excluding managing underwriter, no underwriter is liable in excess of total price of his underwriting offered to public

d. Outside Directors : (1) If the outside director was a knowing violator, JSL; (2) PSLRA added §11(f)(2)(A) to switch to proportionate liability, in absence of knowing misconduct

i. Act 21D(f)(4): Uncollectible Share Liability : If P can’t collect from others, outside directors exposed to greater liability

2. Other defendants’ liability : §11(b) defenses explicitly excludes issuer. Each other party (although joint and several liability) has due diliegence defenses, including (1) Every RS signer; (2) Directors of issuer at time of RS filing; (3) Every person named in the RS as about to become a director; (4) Every accountant, engineer, or any person (generally, experts) named as preparing or certifying any part of the RS; (5) every Underwriter

3. Indemnification :a. Issuer indemnification: For D&O liability who violate S11 against

public policy and hence unenforceable. Directors then just force companies to get D&O insurance, which the SEC does NOT proscribe!

4. Contribution - Act 21D(f)(8) : Outside directors can seek contribution from others, while others can only seek proportionate contribution from outside directors

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5. Settlement Discharge,’34 Act 21D(f)(7) a. A) In General : 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.

b. B) Reduction : 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 % responsibility or amt. paid

6. Statute of limitations - §13 : Suit must be brought w/in 1 yr after material misstatement or omission was or should have been discovered; absolute bar 3 yrs after public offering.

iii. Defenses to Liability – 11b :1. §11(b)(1) – Whistle-blowing : Insider can avoid liability if resigns and notifies

SEC (to alert them that something is amiss) before RS becomes effective2. Due Diligence Defenses – for NON-issuers

a. §11(b)(3)(A) – due diligence defense for non-expertised portions of the RS: 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

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

c. §11(b)(3)(C) – reliance defense for expertised portions of the RS : Non expert reviewing expertised portion. Had NO reasonable ground to believe and DID NOT BELIEVE” that there was any inaccuracy or omission.

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

3. Distinguish expertised vs. nonexpertised: a. Expertised information: Portions of RS certified by expert (financial

info from acting or legal info from lawyer) are referred to as expertise. i. Burden: Expert must show that she conducted a reasonably

investigation and had reasonable ground to believe and did believe that the expertise portion were true and notmisleading

b. Nonexpertised information: Not prepared or reviewed by an expert.i. Burden: D must show that conducted a reasonable

investigation and had ground to believe and did believe that the nonexpertised portions were true and not misleading

c. Reasonableness: Required of reasonable person in the mgmt of his own property. Look to Rule 176 for sliding scale approach that depends on relevant circumstances related to the defendant’s access to the contested information (type of issuer an security, D’s background and relationship to issuer, and D’s responsibility for the info in the RS)

Experitsed Portion Non-expertised Portion

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EXPERT Actually and reasonably believes, after reasonable investigation, that the information is true (ignorance no excuse)

No liability

NONEXPERT No reason to believe that information is false (ignorance is an excuse)

Actually and reasonably believes, after reasonable investigation, that the information is true (ignorance no excuse)

4. Due Diligence test applied - Escott v. BarChris :a. What were the material misstatements : (#1) Misstated financials

[expertise section] and (#2) Misstated plans for use of proceeds [non-expertise section]

b. Due diligence – officers and directors: Varies in relation to 2 factors – (1) director’s access to inside company information, and (2)director’s position as a company insider or nonoutisder employee

i. Inside insiders: Company insiders who perpetrated the coverup of financials and faltering finances were liable

1. Russo (CEO, D, RS signer) : Liable for non-expertised portion MMO about use of proceeds; Liable for expertised financials because he knew they were false

2. Kirchner (company treasurer): Ignorance defense rejected. Knew financials and given his position “must have known” that nonexpertised false asell

ii. Outside Insiders :1. Birnbaum – (Outside D, RS signer, in house lawyer ):

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

iii. Inside Outsiders: 1. Grant (company’s outside lawyer and drafter of RS):

No defense to nonexpertised but yes to expertise2. Can be liable for expertised legal opinions in RS

iv. Outside outsiders: 1. Auslander – (New D (who is also an attorney though

not for the issuer): 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!)

c. Due Diligence – Lawyers : i. Drinker, Biddle – (outside lawyers): Lawyers are not liable

under §11. Considered agents of the UW. Still subject to state law (malpractice) and §10(b)(5)

d. Due Diligence – UW: i. Drexel – (UW) : Failed both expertised and non-expertised

duties. Treated as “insdie outsider” as under D&O’s. ii. Coleman – (UW/D) : expertise defense; but failed due diligence

dutye. Due Diligence – Accountants:

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i. Peat, Marwick (auditors) : liable for the expertised portions. Similar to inside outsiders liability under D&O’s. Should not accept businesses answers at face value w/o further inquiry.

iv. Policy Considerations With Section 11 Liability 1. Evaluating the Due Diligence Regime:

a. Cost ineffective: incredibly expensive undertakingb. Investors may bear substantial cost of diligencec. UWs may under-price offerings to compensate for liability riskd. Competitive bidding by UWs for offerings gives them disincentives to

engage in costly diligence, especially in the shelf. 2. Does strict liability for issuers make sense?:

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

b. Increases cost of capital3. Alternatives to DD regime under S11: Expanding or limiting liable parties?

a. Leave investigation to market forces / reputationb. Limit liability to reckless and intentional violationsc. Limit to issuers and experts who have best access to info/datad. Issuer might be bankrupt by time of suit

i. Expansion of liability and holding other deep pocket parties liable serves compensation and deterrence

e. Attorney liability could create a more accurate and reliable regimei. Lawyers are already doing general due diligence

ii. §11 inconsistent w/SOx notion of lawyers as gatekeeperse. Due Diligence in a Shelf Offering – Worldcom case : Less time to investigate than reg POs

i. Worldcom : civil liability, specter of criminal liability for willful security violations)1. Facts : 2 bond offerings on shelf; misstatements in 2000 and 2001 RS’s2. Audited Financials: UW’s should have recognized E/R anomalies

a. Counterarguments : (1) Info was public and nobody else noticed or reacted; (2) liability obviates efficiency advantages of the shelf

3. Unaudited Financials : Covered by higher due diligence defense, not reliance. UW reliance on comfort letter insufficient. Unreasonable due diligence beyond the comfort letter (cursory investigation; limited contact w/issuer; had knowledge of financial difficulties)

a. Counterarguments : Huge ↑ in UW expenses. Must audit interim financials to avoid liability

4. Rule 176 : Did not protect UWs because level of due diligence in shelf offering is the same as any other offering

f. Rule 176 – Limits on Due Diligence: Attempt to create some safe harbor for due diligence obligations

i. How to apply Rule 176: Look at relevant circumstances, including 1. Reasonable reliance on officers, employees and others2. Type of underwriting arrangement and availability of info3. Whether docs incorporated by reference the defendant had responsibility for

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

4. Suggests that Shelf Registrations do merit special considerationii. Codifies a sliding scale approach to liability : E.g., in BarChris: insiders had greater

duty than outsiders and insiders with special expertise had even higher dutyg. No liability for forward looking statements:

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i. Must show actual knowledge: PSLRA says plaintiff must show that person who made forward looking statement in RS on behalf of an issuer that is a reporting company under the ’34 had actual knowledge that the statement was false or misleading. Excluded are forward looking statements in financial statements or in an IPO.

h. Proportionate liability for outside directors : Exception to rule of joint and several liability. Any outside director can become J&SL only if director knowingly committed a violation of securities laws. Otherwise simply liable for portion of damage that caused.

i. Knowing requires “actual knowledge” : Must have actual knowledge of the material misrepresentation and actual knowledge that persons are reasonably likely to rely on that misrepresentation or omission. Reckless conduct not “knowing”.

i. Role of reliance: i. Reliance not necessary for S11 claim: Proof of reliance unnecessary. P need not have

read RS or prospectus, much less have know of false/misleading info. ii. Only relevant if P knows false or restatement of financials: P cannot recover if D

proves that P knew alleged misinformation false AND reliance element of P’s claim if he bought security after issuer released earnings statement for 1-year period after RS’s effective date.

K. Contrast §11 of ’33 Act w/ §18 of the 1934 Act – Liability for Misstatements in ’34 Act Filings a. S18 of ’34 Act : 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

i. Consider : Focuses on those who actually prepare the financials. Might be better approach than 33 Act §11.

L. Damages Under Section 11(e) a. Negative Causation Defense – For Defendants in S11 Action : 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.

i. Example: If D can show that oil company price stock fell based on WW oil glut rather than misstaetments, P wont’ be able to recover .

ii. Role of negative causation defense : (1) Tempers harshness of §11 liability substantially; (2) Difficult to prove

iii. Applying Negative Causation Defense - Akerman v. Oryx Communications (2d Cir 1987): Upheld negative causation defense when issuer showed the stock price risen when disclosed publicly the alleged false info (IPO =$4.75, SEC disclosure = $4; Public disclosure = $3.25; Suit filed = $3.50)

1. D met §11(e) burden by est. that the misstatements were barely material and that public failed to react adversely to disclosure. Any price decline before disclosure could not be attributed to issuer. Trading market had not become aware of alleged misinformation prior to public disclosure.

b. Measure of Damages Under S11 : §11 creates presumption of rescission damages based on:1. Amount paid (capped at offering price), MINUS:

a. Its value at time of suit,b. Consideration received on resale if sold before suit, orc. Consideration received if sold after suit, but before judgment, IF less

than a) would produce2. Use of “value” lets P argue market price at time of suit was improperly

inflated, to gain larger recovery3. Aggregate Cap, §11(g) : Amt recoverable under §11 will never exceed price at

which security was offered to the public

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4. UW Cap : UW that does not receive special compensation in offering not liable for more than aggregate price of its allotment

ii. Dura Pharmeceuticals v. Broudo (SCOTUS 2005) : In FOTM cases, inflated purchase price is not itself a loss and cannot be the only proximate cause of one. Must show an economic loss, once truth becomes known and price shakes out

Formula #1 – Securities held at the time of judgment

Damages = Purchase Price (not greater than PO price) – value at the time suit brought (11e1)

Formula #2 – Securities sold before suit is brought Damages = Purhcase Price (not greater than PO price) – sales price (11e2)

Formula #3 – Securities sold after suit but before judgment

Damages = Purchase Price (not greater than PO price) – sales price, but not more than damages under #1 (11e3)

c. Compare § 11 to Rule 10b-5: i. Difference between measure of damages in 10b-5 and 11 :

1. S11 : diff between purchase price and the price at which the person sells2. 10b5: No damage cap in 10b-5

ii. Burden of proof : On defendant in Section 11 and on plaintiff in 10b-5iii. Why these differences between 11 and 10b-5?

1. S11 covers the registration statement; S11 more strict liability b/c congress cares more about integrity of reg statement

2. Confers more confidence in public offerings3. It’s a balancing test: to get more damages, have to prove more (10b-5)

M. Section 17a of the ’33 Act :a. General antifraud provision in 17a : Only covers fraud in offer or sale. Supplanted by 10b-5,

created by SEC to cover ALL securities fraud. No private right of actionN. Section 12(a)(1) of the ’33 Act: Liability for offer or sale in violation of Section 5:

a. Statutory provision : “Any person who offers or sells a security in violation of Section 5 shall be liable to the person purchasing the security from him…”

i. What this means: When securities are offered and sold in violation of S5, the purchase may rescind the transaction and get his money back with interest or recover rescissionary damages if he resold his stock.

ii. No misrepresentation required: S12a1 does not require proof of misrepresentation even though section’s purpose to promote full disclosure.

b. Purpose : Enforce the registration and gun-jumping reqm’ts of §5 (generally applies to improperly unregistered securities)

c. Available Remedies : (1) Rescind transaction and get money back + interest, or (2) Recover recissionary damages if stock has been sold.

d. Requires privity : Issuer usually would not be liable then in a major securities offering, it would be the underwriter

e. Strict Liability Standard : SL against statutory sellers of unregistered securities when no exemption applies. Once there’s a violation of §5, later compliance does not cure (eg. defective “offer” during waiting period, is not cured by subsequent compliant sale)

i. See Dicksin v. Lomasney: Noncomplying offer during the waiting period allows for 12a1 rescission even though offer leads to sale that complies with the prospectus delivery reqiurement

f. SOL (SA §13) : Suit must be brought w/in 1 yr after the violation. In no event, more than 3 years after security was bona fide offered to the public.

g. Possible Defendants: Who is a statutory seller for purposes of 12a1?:

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i. Statutory seller : 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).

1. 12(a)(1) : Doesn’t define a seller. It’s whoever has some contractual privity; whoever successfully solicits the purchase, motivated at least in part by a desire to further his own interests (thus aligning him with the issuer for purposes of determining privity).

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

3. Pinter v. Dahl (CB 502) : Oil & gas ventures, investor tells friends and family about it, doesn’t receive commission, helped them complete forms for unregistered securities. Sue Pinter under §12(a)(1) (recession from sellers for failing to comply w/ §5). Pinter sued Dahl for contribution.

a. Holding : 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).

b. Rationale : 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.” Solicitor not a seller under §12a1 if efforts are “gratuitous”. Must be motivated to serve own financial interests, or those of the ‘real’ seller.

i. Note : This definition of “seller” applies to §12(a)(2) too.ii. Collateral Participants not covered : Ct rejected the idea that collateral participants

who helped but did not solicit sales are reached by §12(a)(1)’s SLiii. Inaccurate Prospectuses Trigger Section 12(a)(1) Liability : Misinformation has effect

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

1. §11 liability stems from RS at effective date, rather than prospectus anytime as under §12(a)(2)

O. §12(a)(2) Liability – Misrepresentations in “Public” Offerings a. Applies to : exempt securities, registered securities sold by means of false prospectus, FWPb. Statutory language of 12a2 : Any person who offers or sells a security (whether or not

exempted by §3, other than §3(a)(2) and §3(a)(14)) + [IC] + by means of a prospectus or oral communication (oral communication must relate to the prospectus) + which includes an untrue statement of a material fact, or + omits to state a material fact necessary to make the statements not misleading in the light of the circumstances under which they were made, (the purchaser not knowing of such untruth or omission), and + 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, + shall be liable, subject to subsection (b), to the person purchasing such security from him (privity requirement), who may sue …

i. 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

ii. for damages if he no longer owns the security.c. What does 12a2 mean : 12a2 picks up where S11 left off. Purchases in an offering may seek

rescission from “statutory seller” if the offering was carried out “by means of prospectus or other oral communication” that is materially false or misleading. Sellers have a “reasonable care defense” if they show they did not know (and reasonably could not have known) of the misinformation.

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d. Loss causation under 12a2 : 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.

e. Damages under 12(a)(2) : (1) Recovery of $$ paid + interest (-) income earned on the security, or (2) damages if security is already sold

i. 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.

f. Elements of a 12a2 Rescission Act :i. #1 - Misrepresentation of a material fact: Material untruth or omission of material

fact necessary to make what is said not misleadingii. #2 - Culpability of seller: Seller can defend if can show he did not know or by

exercising reasonable care could not have known1. Reasonable Care (CA7) : UW must have actually performed investigations to

use the “reasonable care” defense. SEC has stated this is not necessary; the “reasonable care” defense s/n/b as difficult to meet as the §11 “due diligence” defense

iii. #3 - Reliance of purchaser : Purchaser need not show he relied, just that he did not know the defect. Some courts place a transaction causation reqm’t, such that the defect had to have been instrumental in making the sale happen

iv. Loss causation defense : 1. Affirmative defense : Loss causation (causal link b/w misinformation and the

plaintiff’s loss) is affirmative defense in 12a2. PSLRA adds §12(b) “loss causation” defense similar to §11 “negative causation” defense.

2. What must show: If D proves that portion/all of amt recoverable represents other than the depreciation in value resulting from false or misleading statement on which liability based, reduce liability accordingly.

g. Possible Defendants in 12a2 Action :i. Seller + Collateral Participants Acting for Value : §12(a)(2) has same language as

§12(a)(1) – “Any person who offers or sells a security”. 1. Under Pinter, it covers 1) seller who passes title, 2) collateral participants who

solicit purchasers for their own or the issuer’s benefitii. Issuer - Issuer Liability under §12(a)(2) – Rule 159A:

1. 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

2. 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.”

a. Result : Issuer can’t argue wasn’t a seller just b/c the UWs who technically sold the securities

h. SOL (SA §13): Suit must be brought w/in 1 yr after discovery of the defect, or after discovery s/h/b made. In no event, more than 3 years after security was bona fide offered to the public

i. Information post-contract of sale too late for purposes of 12(a)(2) liability : Info received by investor after K 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 12a2

j. 12(a)(2) only applies to public offerings (Gustafson) i. Gustafson v. Alloyd Co. (CB 507): Shareholders in closely held corp. sell to investor

group, claim misrepresentation in sale K and seek rescission

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1. Holding : Sale K could not constitute a prospectus under 12a2 b/c not prospectus described in S10 and filed in RS. §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). “prospectus” is a doc that describes a public offering of securities by an issuer or a controlling shareholder, which this K was not.

2. Result : Abandoned case law that said 12a2 applies to both public offerings and exempt private transactions.

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

k. Exempt Transactions still covered by 12(a)(2) : 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.

l. Oral Communications and 12a2: Gustafson dicta suggests that §12(a)(2) liability attaches to oral communications only if they pertain to the prospectus.

Securities Act 12a2Plaintiff PurchaserDefendant Seller + “statutory seller” (person who solicits for

financial interest Predicate Sale or offer by means of prospectus or oral

communication that includes materially false or misleading statement

Sale or offer must be part of a “public offering” (see Gustafson)

Culpability Defense if D did not know or could not have known in exercise of reasonable care

Reliance Purchaser does now know of untruth or omission + sale by means of prospectus or oral communication

Causation Defense – seller shows damages to be other than from depreciation due to false/misleading statement

Liability Not specifiedDamages Consideration paid + “interest thereon” OR damages

if purchaser no longer owns the stockLimitations/Repose One year after discovery of false/misleading

statement, but 3 years after purchase P. Section 15 – Control Person Liability : Control persons who control anyone who could be liable under

Sections 11 and 12 shall also be jointly and severally liable unless the controlling person lacks knowledge and/or reason to believe the existence of facts upon which the liability of the controlled person is said to exist.

Q. Section 17 – SEC Antifraud Enforcement a. Application to the SEC : S11, 12a1, and 12a2 of ’33 Act not applicable to SEC, which is not party

to the transactions. S17 generally prohibits fraud in connection with any offer or sale of securities. For case law, see Aaron v. SEC

i. 17a1 : Makes it unlawful to employ any device, scheme, or artifice to defraud – evinces intent only to proscribe “knowing or intentional misconduct”

ii. 17a2: Prohibits any person from obtaining $ or property by any means of untrue statement of a material fact or any omission to state a material fact - no scienter

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iii. 17a3: Unlawful for any person to engage in any transaction, practice ,or course of business which operates or would operate as a fraud or deceit – effect rather than culpability, no scienter

b. Applies to both offers AND sales : 17a1 prohibits fraud against brokers as well as purchaser-investors, see US v. Naftalin, applies to persons generally, in addition to purchasers of securities

R. Rule 10b-5 (Always there, When All Else Fails) a. General prohibition : It shall be unlawful for any person to use any instrumentality of interstate

commerce, or of the mails, or of any facility of any national securities exchange, to:i. Employ any device, scheme, or artifice to defraud

ii. To make any untrue statement of a material fact or to omit a material fact necessary to make the statements made not misleading, or

iii. To engage in any act, practice, or course of business which would operate as fraud or deceit upon any person

iv. In connection with the purchase or sale of any securityv. Need scienter (Ernst & Ernst)

vi. Reliance requirementvii. Damages : Doesn’t matter what the offering price was; what plaintiff paid – price at

time of suit or saleS. Comparing Liability Provisions: Sections 11, 12, 10b-5

a. Don’t overlook 10b5 : 10b-5 applies to everything, when all else fails use thatb. Registration process : Strictest rules are under Section 11 and Section 12(a)(1) w/r/t

registration processc. Exempt securities still covered by the antifraud provisions : Most exempt securities are

covered under Section 12(a)(2) when they are not covered by other sectionsi. Section 3(a)(3) securities (debt with maturity < 9 mos.) are a kind of exempt security,

but they are covered under 12(a)(2) d. Private offerings, 10b5 only: Private offerings are only covered by 10b-5

Chapter 12: Fraud in Connection with the Purchase or Sale of a Security

A. Overview, “ In Connection With, ” Standing, and Scienter, pp. 659-662, 667-68, 671-74, Problems 12-1 to 12-3

a. Rule 10b5 language: 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,

i. (a) to employ any device, scheme or artifice to defraud, [SCIENTER]ii. (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

iii. (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

iv. in connection with the purchase or sale of any security.b. Rule 10b5 generally: Accept that 10b5 proscribes fraud that touches on the purchase or sale

of any security, reaching misbehavior running from the smallest closely held corporation to the largest blue chip issuers, so long as the misconduct is intentional and truly deceptive in nature. Also accept that enforceable publicly and by an implied right of action.

c. How to do a 10b5 analysis: i. #1 – Look to language of statute

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ii. #2 – Identify a securities purchase or sale: 10b and 10b5 apply to “purchase or sale of security”; once ID security, ID a purchase by an investor or a sale by existing holder. Applies to both securities publicly traded or closely held, whether subject to registration or not

iii. #3 – ID deception “in connection with” the securities transaction: Apply to any person who engages in prohibited behavior “in connection with” a securities transaction. No privity requirement. Applies even to persons/entities that are not parties to a securities transaction as long as behavior affects the transactions.

iv. #4 – Check for J/D requirements: Must have use of an instrumentality of IC, mails, or securities exchange

v. #5 – Check for procedural limitations imposed by PSLRA: Class actions disfavored. Will only certify if in efficient market (Cammer factors) and that fraud affected the price. Lead plaintiff must be most adequate/heightened pleading/etc.

vi. #6 – Check whether brought in federal court : 10b5 violations must be brought in federal district court. Class actions must be brought in federal court. Class actions that allege fiduciary breaches under state corporate law may be brought in state court (Delaware carve out)

d. When do 10b5 suits typically arise : 3 situations generallyi. Securities trading : Party to securities transaction gives false or misleading info to

induce other party to enter into the transaction, or remains silent when have duty to disclose.

ii. Corporate trading : Corporate mgr induces her corporation to enter into a disadvantageous securities transaction and corporation/shareholder sues.

iii. Corporate disclosures: Corporation (w/ o trading) issues false or misleading information to the public about its securities, or remains silent when it has a duty to dislcosue. Purchasers or sellers sue the corporation for their trading losses.

e. Two requirements (at minimum) for 1b5 action: i. Fraud: Must have fraud either in the form of an affirmative misrepresentation or some

sort of device, scheme or artifice to defraudii. In Connection with the sales of securities : The fraud must be in connection with the

purchase or sales of securities. Focus is on the link b/w the defendant’s fraud and purchases or sales of securities by the victims

1. Case law – Texas Gulf Sulphur (CA2): “In connection with” requirement satisfied by showing that the false corporate publicity was disseminated in a manner “reasonably calculated to influence the investing public.” Person who commits fraud conceivably bears liability to the entire marketplace.

2. Fraudulent purpose not required with dissemination: Not necessary to show that the purpose of the misleading statement was to influence investors, only that a material misstatement was disseminated in a medium on which investors rely. Recipient of information need not be a person to whom it was specifically directed.

3. Essential: Fraud must relate to investment activity of the sort that Congress seeking to protect with the securities laws. Investment aspect must be essential to the wrongful scheme rather than incidental.

f. Purchasers and Sellers – 10b5 Standing: i. Who has standing: Only actual purchasers and sellers may recover in a private action

under 10b5 (see Blue Chips/Birnbaum). 1. Result – does not covers offer, only sales: Even if a false or misleading

statement leads a person to not buy or sell a security with financial results as

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damaging as if the person had been induced to trade, there is no 10b5 liability. Does not cover offers to sell but only actual sales and purchases.

2. No exceptions: Lower courts have read Blue Chips as precluding any exceptions to purchaser/seller rule for standing.

3. What about class actions: Lead plaintiff must be most adequate, presumed as investor w/l argest financial interest.

g. Primary Violators – Defendants in 10b5: i. Who can be a defendant: No privity requirement under 10b5. Any person who makes

false or misleading statements and induces others to trade to their detriment (primary violators) can become liable. Corporate officials who make statements about corporation or its securities can be liable for 10b5 even if no trading occurs.

1. Control persons: J&SL on any person who controls a primary violator, unless CP shows that acted in good faith and did not induce the violation. (showing of affirmative effort needed for GF defense)

2. Primary violators : 10b5 defendants must engage in the actual fraudulent or deceptive behavior upon which the plaintiff replied, not merely collateral assistance.

a. Secondary participants: Some courts hold UWs, lawyers, and accountants liable for role in drafting and editing docs that contain misrepresentations even though not mentioned in the docs and docs disseminated by others.

i. BUT: Other cts have held that primary violators must actually make the misstatements to investors or have it attributed to them.

ii. SEC argument: Secondary parties only liable if they “create” a misrepresentation on which investors rely

h. “In connection with” standard for 10b5: i. “In connection with” standard: Must show deception and fraud “in connection with”

the sale or purchaser of securities. No privity required. Established even when makes disclosures to a public trading market that it does not actually envision will trigger reliance.

1. Case law – Zandford: Statements can be actionable as breach of FD and fraud in connection with securities transaction

2. Case law – O’Hagan: Fraudulent use of confidential information is “in connection with” securities trading based on that information. Lawyer’s unauthorized use of client confidences was deceptive and in connection with a securities transaction

3. Case law – Bankers Life: Enough that fraud “touches” the sale of securities.ii. Sale of business doctrine: See Landreth, 10b5 applies to any purchase or sale of

securitiese, including the sale of a business structured as a stock sale.B. Fraud Elements of a Private 10b5 Action: (1) material misinformation, (2) scienter, (3) reliance, (4)

causation, (5) damagesa. Elements #1 - Material misinformation: Affirmative misrepresentation of a material fact, or

omitted fact that made statement misleading, or remained silent in face of duty to disclose a fact, or duty to update

i. Oral representations count too: 10b5 covers deception in an oral K for the sale of securities despite difficulties in proof

ii. Materiality – Basic v. Levinson test: Information material for 10b5 if there is a substantial likelihood that a reasonable investor would (not might) consider it altering the “total mix” of information in deciding whether to buy or sell

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iii. Also applies to manipulation: Can’t have securities activities that manipulate the price of securities by creating false impression of market activity (eg, trader buys and sells to raise prices)

iv. Duty to speak: Silence only actionable if duty to speak. Occurs when relationship of trust and confidence where would be proper to be compelled to speak (see Affiliated Ute Citizens v US). Can also apply where closely held corporation dealing with shareholder employees.

v. Duty to update: Arise when forward looking statements alive in the market and have become inaccurate (eg, public announcement of plan to fix leverage and then consider dilutive stock offering, must update). If make forward looking statement, must speak when market relies on the statements.

vi. Corporate mismanagement: 10b5 only applies when deception, not when unfair cororpate transactions or breaches of FD (see Santa Fe Industries, SCOTUS)

b. Scienter: Plaintiff must plead and prove the defendant’s scienter, meaning a “mental state embracing intent to deceive, manipulate, or defraud” (Ernst and Ernst)

i. Negligence not actionable : Per Ernst & Ernst v. Hochfelder, private 10b-5 actions must show D acted w/scienter in order for the claim to succeed (“intent to deceive, manipulate, or defraud”). No negligence actionable.

1. Same std across the board: Scienter standard applies whether SEC, private plaintiff, seeks injunctive relief or damages.

ii. Meaning of scienter : Vaguely defined: whether, alleged from the facts from which a reasonable person could infer the ∆ acted with intent.

1. Dominant view: 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)

2. Reckless might be ok too: Authority suggests that recklessness constitutes scienter for liability purposes under 10b-5. Can exist when circumstantial evidence strongly suggests actual knowledge.

iii. Whose scienter applies when dealing with corporation: Generally look to the sum of the knowledge:

1. Tellabs standard differs (CA7) : Look to the intent/knowledge/recklessness of the executives issuing the reports; you can’t look to collective knowledge or intent by adding up the knowledge of lower employees. If lower employees definitely lied and defrauded, but the execs were merely careless in not discovering this, then the requisite scienter is not met.

a. Be sure to separate scienter from materiality requirement:iv. Criminal vs. civil : 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. Scienter requirement higher for criminal 10b-5 claim than for a civil 10b-5 claim

v. 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))2. If it is = as another inference, you get past the scienter pleading requirement3. We can’t really have a way of knowing the effect this has had on frivolous class

actions, but it hasn’t contained the absolute # of class actionsc. Reliance: Plaintiff must rely on the misrepresentation. If involve duty to speak, presume

reliance if material information. If impersonal trading market, infer reliance from dissemination of misinformation in the trading markets.

i. General Test : Did the misrepresentation cause the plaintiff to buy or sell? (AUSA Life Ins.). Tests the link b/w alleged misinformation and plaintiff’s buy-sell decision.

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ii. Nondisclosure when duty to speak: Presumption of reliance when there is omission of material facts/lack of disclosure of material facts (eg., if reasonable investors would have considered the fact important) (Ute).

iii. Fraud on the market - no reliance required : Rebuttable presumption of reliance when there is a misrepresentation (Basic). In market transactions, “market is interposed between seller and buyer and, ideally, transmits information to the investor in the processed form of a market price” buyer relies on integrity of the market (Basic)

1. Impossibliity : It’s nearly impossible to prove reliance with FOTM (imposing a higher burden would effectively eliminate Class Action’s under 10b-5)

2. What is Fraud on the Market : People assume when they buy stock on the market, it reflects accurately the value of the company.

a. But see Basic dissent : White says this doctrine is flawed b/c people buy/sell precisely on belief that market price does not accurately reflect value (and they’re trying to profit on that when it fluctuates)

b. SCOTUS : Claims that empirical studies support the ECMH, which suggests that any misinformation in the market will impact the price

d. Causation: Plaintiff must suffer actual losses proximately caused by the misrepresentationi. Plaintiff must prove two types of causation : transaction causation (which is basically

reliance) & loss causation. 1. Transaction causation: but for the D’s fraud, plaintiff would not have entered

the transaction or would have entered under different terms2. Loss causation : P must show that alleged misrepresentation or omissions

resulted in the claimed loss (forseeability or proximate cause requirement) (see AUSA Life Insurance)

a. Language : 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. (see PSLRA 21D(b)(4))

b. Compare with negative causation defense: Here P must prove causation (rather than D disproving causation). Loss causation under 10b5 is converse of negative causation defense under S11

c. Burden of proof with Ps : Must prove causation, often means that will have task of negating extraneous causes for their losses. Cannot use FOTM presumption to show that alleged fraud produced an effect on stock prices

d. How to prove loss causation : inflated purchase price not enough, can use foreseeability test

i. FOTM – overstatement of price (Dura) : Artificially inflated purchase price on itself a relevant economic loss

1. No liability attaches based on lack of causation simply based on an inflated purchase price. Inflated purchase price will not itself constitute or proximately cause the relevant economic loss. Dura (‘05, SCOTUS)

ii. Foreseeability test (AUSA, 2 nd C) : Causation should be dealt with under a foreseeability test; like a tort standard of causation (reasonably foreseeable). Focus is on acquisition rather than the loss of investors. If it cased the acquisition, therefore it caused the loss. He doesn’t go further than that to showing a causal link to investors’ loss.

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1. Concurrence - foreseeability : Should ask whether it was foreseeable that E&Y’s statement of accounts would cause the plaintiffs to suffer losses; not whether it would be foreseeable to cause the acquisition- that they would actually cause a loss to investors.

2. Dissent - looks mistakenly at reliance : whether investors would have invested in notes if known were dealing with mgmt that misstated financial info

e. Damages: Must cause damages to recover (punitive not available). Have full range of equitable and legal remedies for P’s who succeed on 10b5 claim.

i. Only actual damages : P only gets damages for amount of loss the D actually caused (CAUSATION ELEMENT). Losses cannot exceed actual damages since point is compensation for losses (just like K’s).

ii. Various theories of recovery: Both legal and equitable damages recoverable1. Rescission: Defrauded P can cancel the transaction (only for F2F transactions).2. Rescissionary damages: If stock has been resold, get diff. b/w purchase price

and resale price.3. Cover (conversion) damages: Diff. b/w price that transacted at and price at

which could have transacted once the fraud revealed.4. Out of pocket damages (MOST COMMON): Diff. b/w the purchase price and

the true price of the stock at the time of the purchase. (diff. w/ purchase price and stock’s “but for” value)

iii. Damages Cap: PSLRA says when recovery is based on the market price of the stock, there is a damages cap. Diff. b/w the transacted at price and the average of the daily prices during the 90-day period following the corrective disclosure.

iv. CONSIDER – Subsidization: When a corporation pays damages, effect will be one set of shareholders subsidizing another set of shareholders. Mgrs not impacted by 10b5 litigation such that it imposes costs, but no financial gains, on investors.

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Rule 10b5Plaintiff Purchaser or seller

Defendant Primary violator – person who engages in fraudulent (or deceptive) conduct on which purchaser or seller relies

Predicate Purchase or sale of materially false or misleading statement (or silence when under duty to speak)

Culpability Element – defendant’s scienter (knowledge or reckless disregard of the truth)

Reliance Element – actual and reasonable reliance, unless actionable silence (duty to disclose/update) or fraud on the market

Causation Element – deception proximately caused losses

Damages Recission, cover, out of pocket or K damages but not atty fees

Liability J&SL plus right of contribution

Limitations 2 years after discovery of facts constituting violation but no more than 5 years after violation

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EXCHANGE ACT LIABILITY

Rule 10b-5 18a 9eCoverage Sale or offer of securities SEC filing Trading in securities

listed on stock exchangePlaintiff Purchaser or seller Purchaser or seller of

affected securitiesPurchaser or seller of manipulated securities

Defendant Primary violator Person who makes false statement in filing with the SEC

Will participant in manipulative conduct

Violation Misrepresentation or omission of material fact in connection with purchase or sale of any security

False or misleading statement w/r/t material fact in SEC filing

Specified manipulative practices

Culpability Scienter required (includes recklessness)

Defense: good faith and no knowledge of falsity

Required (willfull participation)

Reliance Reliance required (unless case involves duty to speak or omission)

Reliance required N/A

Causation Loss causation Price affected by statement

Price affected by violation

Remedy Generally out of pocket damages

Damages caused by reliance

Damages sustained as result of violation

Limited liability Proportional liability for unknowing violators

N/A N/A

Contribution Available Available Available

Limitations Period 2 years after discovery/5 years after violation

2 years after discovery/5 years after violation

2 years after discovery/5 years after violation

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SECURITIES ACT LIABILITY

S11 S12a1 S12a2Coverage Registered offering Unregistered, nonexempt

offeringPublic offering

Plaintiff Acquirer of registered securities

Purchaser of unregistered securities

Purchaser of securities

Defendant Issuer, directors, specified officers, experts, UWs

Statutory seller (person who solicits for personal gain)

Statutory seller (person who solicits for personal gain)

Violation Untrue statement or misleading omission of material fact in RS

Violation of S5 (sale or offer of unregistered securities

Offer or sale by means of prospectus or oral communication containing materially false or misleading statement

Culpability Strict liability (issuer)Due diligence defenses (non issuer D’s)

N/A Defense: reasonable care and no knowledge

Reliance Not required (defense if income statement filed 12 months after offering)

N/A Defense if purchaser knows untruth or omission

No reliance requirement for plaintiff

Causation Defense (negative causation)

N/A Defense (negative causation)

Remedy Damages formula (capped at aggregate offering price)

Rescission or rescissionary damages

Rescission or rescissionary damages

Limited liability Proportional liability for unknowing outsider directors

N/A N/A

Contribution Available (as in cases of K)

N/A N/A

Limitations Period 1 year after discovery/3 after offering (perhaps 2/5 years if fraud)

1 year after violation 1 year after discovery/3 after offering (perhaps 2/5 years if fraud)

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