Securities Regulation Spindler Fall2013 Kreshover

7/26/2019 Securities Regulation Spindler Fall2013 Kreshover

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Securities Regulation Outline

Introduction to Securities Law

Why have Securities? Starting with East Indian Company, companies became too large for one person to finance, so

people bought share certificates to own a piece of the company. Now there are no certificates because DTC holds all of them. Brokers call DTC to make trades. The SEC is there to protect unsophisticated investors from being taken advantage of in the stock

marketplace by big investment banks and sophisticated investors. If there was no protection, ordinary investors would lose confidence in the marketplace being

a level playing field and a big source of capital markets dries up which hurts the economy.

The marketplace lowers transaction costs, so without the public it will lead to much highertransaction costs for every attempt to sell the securities.

SECmission: protect investors, maintain fair, orderly, and efficient markets, and facilitate capitalformation. Organization: 5 presidentially appointed commissioners, 4 Divisions

Division of Corporation Financereviews filings of publicly held corporations

Division of Trading and Marketsday-to-day oversight

Division of Investment Managementreviews disclosure of investment funds

Division of Enforcementrecommends investigations, actions, and prosecutes cases

Division of Risk Strategy and Financial Innovationdeveloped after 2008 crash; analyzesnew market trends for risks to the market.

Responsibilities: Interpret fed securities laws; issue new rules and amend existing rules; oversee

inspection of securities firms, brokers, investment advisers, and ratings agencies; oversee privateregulatory orgs in securities, accounting, and auditing fields; and coordinate with foreign law

3 Types of Securities Offerings Registered(Securities Act) Exempt

Private Placements

Rule 4(a)(2)

Rule 506

Rule 144A

Intrastate Companies

Limited Offerings and quasi-private placements

Reg A

Reg D (Rules 504-506)

Offshore (Reg S.)

Resales (144, 144A, 4(a)(1)) Illegal

Recent Trends in Security Litigation and Transactions

Sarbanes-Oxley made it very expensive to be a small public company This means that there are fewer deals, but more, larger deals.

More lawsuits today over mergers.

Many of these are aiding and abetting suits against officers and other companies involvedbecause the actual company may be bankrupt if it is in this kind of trouble.

Going Public can happen in two ways 1. Public Sale of Securities (IPO)this requires Registration under the Securities Act 2. Gain Public Company Statusthis requires registration under the Exchange Act

Widely Held: 2000 shareholders of record or 500 unaccredited SH of record

Done a public offering


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Elect to be public. Benefits of going public: capital is easier than getting private investors, liquidity increases if

shares can be sold on market, risk shifting/cashing out, prestige, reputation, credibility. Costs of going public: offering cost (7% underwriter commission, legal, printing), time of

management, liability possibility, diminishes control unless you make separate classes of stock,efficiency issues (usually sell for less than it is really worth).

Factors for whether you should go public:

Companys Size$20MM in annual sales and $1MM net income in current year

Financial Ratios and Historic Performancedebt-equity ratio, liquidity, debt coverageshould all be in line with industry average; need 12 to 15% growth per year.

Current Managementhigh-quality executives with broad experience.

Public Appeal of Businessgrowing industry, be an industry leader or have a niche.

Market Conditions Steps of an IPO on page 32 of the book.

What is a Security? Anything can be a security if its an investment where you expect to earn profits on labor of others

SEV v. W.J. Howey Co. shows how oranges can be a security.

Investors bought land on orange farm.

With the land investorspurchased service contractin which Howey would take care ofthe land and distribute profits to the investorsdeemed to be security in orange field.


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Securities Act of 1933truth in securities law

Objectives Require investors receive info concerning securities being offered for public sale (disclosure) Prohibit deceit, misrepresentations, and other fraud in the sale of securities (anti-fraud)

Definitions Securities(2(a)(1))provides a long list of instruments and such + investment contracts

4 part Test

What is the item in question? Name of item is not dispositive If a stock entitles you to an apartment in a housing project, it is not likely a stock

unless it is traded like a stock.

Look to Section 2(a)(1) list

If it is not listed, is it an investment contract?

No meaning of investment contract, so courts have created a test.

Basic question is if mandatory disclosure rules would be useful in court. Howey Test:

Investment of Money

Noncontributory, compulsory pension plan is not an investment

Laborer is selling his labor as a way to make a living, not an investment.

With Expectation of Profit

Profits = capital appreciation resulting from the development of the initialinvestment or a participation in earnings resulting from the use ofinvestors funds.

If instead, purchaser is motivated to occupy the land purchased or use theitem for some sort of consumption, it is not for profit. United Housing.

Fixed return does not preclude it from being for profit.Edwards

$7k to buy payphone and immediately lease it back for $7k+14%

Looks the exact same as a debt agreement, so it is a security.

In Common Enterprise Horizontal Commonalityother investors are similarly situated so there is

some privity between you.

If there is only one investor, he will do his due diligence and gather asmuch info as possible on the company

If there are many similar investors, company doesnt want each onecoming through its doors and going through its files.

If investors are the public, not sophisticated enough to coordinate.Instead the company does the diligence and reports it for them.

Vertical Commonalityinvestors fortunes align with company

Somehow must be in privity with issuer.

A little redundant based on 4thcriterion. Issuer has info that investor needs, makes sense to force disclosure.

Two formulations by courts1. Strict Vertical Commonalityfortunes of investor linked tofortunesof promoter or third party.2. Broad Vertical Commonalityfortunes of investor linked to effortsof promoter or third party.

Koscotsays even if it is your own efforts creating it, if your effortsare based on higher organizational efficacy, then that is enough.(fraud cases make bad results)


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Solely from the efforts of others

Efforts cannot arise before the time of the sale. Must be post-purchaseefforts.

Life Partnersinvolved a company picking life insurance policies beforeselling pieces of the pie. Investors could research who is in the pie.

Ministerial Functions (collecting policy, distributing money, etc.) is notimportant for security definition. Efforts must be entrepreneurial and pos-purchase.

Ministerial versus Managerial Efforts

If it is not listeddoes context otherwise require it not to be a security?

Bank accounts are an example. Although they fit the other aspects of this(especially because fixed returns arent an issue), insured by the FDIC, regulated by

federal government in other waysdisclosure isnt as necessary. Sale of Business Doctrinewhen a corporate business is sold by means of a sale of

the corporations stock, the stock is not a security as the term is used in the Act

Landreth Timber rejected this rule. Stock is stock.

Would require all sales of businesses by stock sale to meet registrationrequirementsvery illogical.

Reeves 4 factor testfor whether a promissory note is a Security Purpose of the Transaction

Seller: raising money for capital; Buyer: make profitsecurity

Facilitating a transaction (purchasing inventory on credit, buying a car onfinancing)not a security

Plan of Distributionspeculation or investment?

Determines how widely a note will be traded

If it is held for speculation, more likely to be traded and 3rdparty needssource of information, so more disclosure is good.

If it is held for investment, it will stay a one-one transaction and buyer canget his own information.

Reasonable Expectations of Investing Publicwould the public think thatthe purchase they are making is regulated by federal securities law?

Other Regulatory SchemeFDIC, Banking Regulations, etc. reduce needfor disclosure because they are already being handled by other scheme.

Evidence of Indebtednessis another mushy term used in definition

Refundable airline ticket not an evidence of indebtedness. Not a primary obligation topay a sum of money. U.S. v. Jones.

CD is not a security because banks are insured and heavily regulated.Marine Bank.

Sale of a Franchise is a security because you could cash it in and get your deposit back.In re Tucker Corp.

Swap agreementstwo creditors exchange interest rates so one gets a fixed rate for

more stable interest and the other takes a floating rate with more risk.

Proctor and Gamblesays not a security because evidence of indebtedness requirespayment of principle.

2A of the 33 Act specifically excludes individually negotiated swaptransactions from definition of security. However, left open for courts by excludingany note, bond, or evidence of indebtedness that is a security from the definition

Credit Default Swapsbuyer pays basically insurance premium to seller. Sellerinsures buyer in case of bond failure. If the financial outlook of the bond turns sour(because company isnt doing well), CDS worth more and can be resold on market.

Neither party needs to hold the underlying debt when transaction entered.


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Debt vs. Equity

Debt (e.g. loans, notes, debentures, indentures): company is a borrower, creditor givesthe borrower cash.

Company sells a $1MM IOU to a company for $800k.

Equity has right to the residual, so it is given to an investor, not a creditor.

Equity-holder has interest in how company actually does, because they only getshare of residual profits. NO GUARANTEED AMOUNT.

Creditors get paid first, then equity holders get what is left over.

Unlimited upside, but nothing until creditors are paid in full. BOTH ARE SECURITIESonly need some profit-seeking interest.

Asset-Backed Securities

Securitization solves the problems that arise when trying to sell a collection of assets. Too expensive to buy all of them. Too risky to buy any individual one.

Create Special Purpose Vehicle (SPV) that owns all of the assets.

SPV gives a note for value to the owner, and the owner transfers the assets.

SPV then issues bonds and bondholders give the SPV the money to pay off the note

Decreases the risk because bonds are guaranteed debt rather than risky asset

As income from the asset comes in (royalties, mortgage payments, etc.), useincome to service bondholders.

Purpose of the SPV is to limit liability on the true owner.

Prospectus(2(a)(10), Rule 430)any written offer, offer by radio or television, or confirmationof sale.

10(a) prospectusis complete with no blanks. It includes the info on the registrationstatement.

10(b)/Rule 430 preliminary prospectusallows some blanks in the waiting period for thingslike price and other things that arent decided. Rule 401 directs a company to the correctform.

Free Writing Prospectus(Rule 164/433)Allows updates and fixes for mistakes and omissions

in prospectus, but it must have a legend and be filed. If you follow 433you have a 10(b) prospectus.

If you are a WKSIonce filed 430 prospectus, the issuer can freely use FWP

Non-reporting and unseasoned issuers it depends on if issuer prepared or paid for the FWP

If yesthey must accompany or precede it with a 430 prospectus

If nodont need to accompany or precede by a 430 prospectus

433(f) gives an exception for FWP prepared by bona-fide media.

433(c) governs content. Offers(2(a)(3))every attempt or offer to dispose of, or solicitation of an offer to buy, a security

or interest in a security, for value.

Any statement, written or oral, that conditionsmarket for the issuers securities is an offer.

Securities Act Release No. 3844 introduced conditioning concept and gave examples. Loeb, Rhoadesmakes press releases about issuer a public offer. As a result, Release 5180

provides issuers with guidelines for press releases in pre-filing period that advise againstforecasts, projections, or predictions relating but not limited to revenues, income, or earnignsper share and publishing opinions concerning values.

Exception for Offers and Sales if it ispreliminary negotiation with underwriterfor purposesof 5(c). However, this doesnt apply to dealers who hold onto the security for their ownportfolio, so underwriter must purchase with a view to distribute the security.

Sales(2(a)(3))every contract of sale or dispositionof a security or interest in security, forvalue.


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Disposition can be broader than a final contract of sale.

In re Franklin, Meyer & Barnett: putting yourself in the position to cash someones check is

enough to be a sale.

Acquisitions

Commission formerly used form over substance analysis saying stock-for-stock mergerswere sales, but stock-for-assets were not sales of securities.

Release 5316 changed course and paved the way for rule 145.

Now if securities are exchanged for assets and provides for dissolution of asset-sellingcompanysale of securities.

Rule 145

Submission to vote to SH of a merger = offer to sell/sale.

Release 5463acquirer can elect to use private placement exemption instead ofregistering the securities if he is acquiring a private company, but not a public company.

Spin OffsCompany sells bad asset to a wholly owned subsidiary, then distributes shares inthe subsidiary to its SH. Result is publicly traded company that has no disclosure and a badasset.

1997 Staff Legal bulletin provides a 5 factor test for whether this is deemed to be a sale.

If you meet all 5 factors, then this is nota sale:

Pro-rata distribution to SH No Consideration from recipients

If you are paying consideration, you are giving something up and making aninvestment decision

If you are making an investment decision, securities law would help you

Adequate information provided about spin-off and spin-off company to its SHand to the public.

SH might go sell to someone else who is making an investment decision

Must have some disclosure if trading securities.

Valid Business Purpose

Main VBP is to get an asset off of your books

Datatronics was merely facilitating private companies going public withoutregistering under the act.

2 Years no sales on Restricted Securities (now 1 year under rule 144)

Issuer(2(a)(4))every person who issues or proposes to issue any security.

Many exceptions apply.

Types of issuers

Non-reporting issuer (company doing an IPO)

Unseasoned Issuerrequired to file reports under Exchange Act/voluntarily doing so,but they are not seasoned issuers

Seasoned Issuer (Rule 433(b))filed reports under Exchange Act for at least 12 monthsand either have $75MM equity or offering investment grade non-convertible debt.

Well-known Seasoned Issuer (Rule 405): Google, MS, IBM, etc.

$700MM common equity held by non-affiliates or issued for cash >$1B ofregistered non-convertible securities other than common equity in last three years

Emerging Growth Company (JOBS Act 2(a)(19))) Underwriter(2(a)(11))Purchase securities from issuer with a view to distribution of such

securities.

Types of Underwriting

Firm CommitmentUnderwriter (and its syndicate) purchase securities from the firm atan agreed price and distributes it amongst the syndicate at agreed percentage allocations.


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The syndicate then sells the securities to the public and makes a profit or loss based onits percentage of the block. The head underwriter gets a fee from the proceeds.

Best EffortsUW sells the most that it can (less risk to UW)

Standbycorp. offers securities to existing SH, those that arent purchased are boughtby UW. Variation of firm commitment.

Broad use of issuer in the definition to include control persons Dealer(2(a)(12))

Distinction between dealer and broker: in the industry, despite what Securities Act says, a

dealer trades for his own account and takes title before selling while a broker serves as anintermediary and never takes title to the stock.

Emerging Growth Company(2(a)(19))Company with revenue of less than $1B

Allowed to file confidential registration statements so no one will know if you changesomething or withdraw.

Registration for Public Offerings of Securities Must make all material information available to the public when you are making a public

offering of securities.

33 Act has mandatory disclosure requirements, forms of disclosure, and prohibitions onother disclosures.

First a company must file a registration statement, and then once it is made effective by theSEC, they can sell securities.

General information required by registration statement

Description of properties and business

Description of security to be offered for sale

Info about management of company

Financial statements certified by independent accountants.

3 PeriodsSecurities Act 5 (CHART ON PG 79)

Pre-filing Period 5(a),(c)no offers or sales of securities before registration statementfiled.

Non-reporting Issuer

Allowed Preliminary negotiations and agreements with underwriters

Exception put in 2(a)(3) to offers and sales for the purposes of 5(c)

Rule 135 Communications

Allows purely informational statements explaining an offer is taking place

Only allows for when and where it is happening, manner and purpose.

No substantive information is allowed, not even name of UW.

Legend: statement that it does not constitute an offer of securities for sale

Rule 163A Communications

Communications that dontmention the offering, but might condition themarket in some waycan wait 30 days and fit in this safe harbor.

If your statement mentions the offering, there is no bright-line rule andyou dont know how long you have to wait. May never be able to makethe offering.

Still must take reasonable steps to stop further dissemination ofstatements.

Doesnt apply to certain communications under 163A(b)

Rule 169 Communications

Regularly released factual information in the ordinary course of businesswill not violate 5(c)

Major question here is if youve released similar statements in the past.


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Level of subjectivity on the part of an SEC investigationif you intendedthis to condition the market, they will likely find it did.

Can post company updates to websites, but just prior to an offering itlooks bad.

Unseasoned and Seasoned Issuers

May do all the same things as a non-reporting issuer PLUS

Regularly-released forward-looking information under Rule 168

Special privilege for public companies allowing them to make a statement

about the future of the company Formerly prohibited, but this is information investors want to value the

company with b/cpast information doesnt help much with how the companywill fare next year.

Seasoned Issuers can file on form S-3 which is also known as a shelf offering and

allows them to have registration statements ready in advance

Well-Known Seasoned Issuers (defined in Rule 405) May do all the same things as unseasoned/seasoned issuers PLUS May make oral offers at any time (Rule 163)

May give free writing prospectuses at any time without accompanying or precedingthem by any other prospectus (Rule 163).

Legend

Retained for 3 years

Be filed with Commission Although they can make oral and written offers at any time, WKSI still liable for

fraudulent statements.

Emerging Growth Companies Test the waters with QIBs and AIAs (5(d)) Research Reports by broker/dealers are ok (2(a)(3))

Waiting PeriodSEC reviews your registration statement.

Only 5(a) and (b) apply here. 5(c) is done.

Oral offers are now allowed. Written offers are not unless they are 10 prospectus. Giving presentations is ok, but you couldnt give out copies afterwards. Anyrecorded medium is not okay unless it is a 10 prospectus. (5(b)(1))

Allowable activities

Non Reporting

Oral Offers are now allowed.

Preliminary negotiations and agreements with underwriters

Rule 134 Communication

Section 10 Prospectus

Preliminary (Section 10(b) and Rule 430)

Summary (Rule 431)

Free Writing (Section 10(b) and Rules 164/433); must be accompanied orpreceded by preliminary prospectus.

Issuer must distribute prospectus to UW to have RS accelerated. Release 4968.

Brokers and UW must distribute preliminary prospectus according to R. 15c2-8 Unseasoned Issuers do not have to deliver a prospectus with offers according to

15c2-8 because they are already a reporting company, so they have publicinformation.

Seasoned Issuers dont have to send a prospectus with or before a FWP under433(b)(2)


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Well-Known Seasoned Issuers have no waiting period. Sales are availableimmediately after filing the registration statement.

Post-Effective Period

5(a) no longer applies so issuer can sell securities now.

Permissible Communications

5(b)(1) says any prospectus must be 10 compliant.

R. 430 doesnt apply nowpreliminary prospectuses arent 10 compliant

Manor Nursingsays if too much incorrect infoit isnt 10(a) compliant.

1stcircuit adopted this, but the 5 thcircuit did not

Could argue if its misleading, fraud claim is better thanSEC enforcementaction.

If you make fraud a Sec. 5 violation, Sec. 11 is redundant.

Generally updates to the prospectus will be made with a 424(b) prospectus

Free Writings are still allowed under Rule 433, but if you are a non-reportingcompany you must still accompany or precede FWP with a 10(a) prospectus.

2(a)(10)(a) says this is not a prospectus if accompanied or preceded. Rule 134 Tombstone Ads

Ads for sale of security in a newspaper

Can only describe general nature of the markets and strategies. Need disclosures: risks, no past or projected performance figures, no

recommendation to purchase or sell is made, dont reference specific stocks.

Delivery and Confirmation

5(b)(2) requires delivery of security to be accompanied or preceded by 10(a)prospectus

R. 172(a) exempts confirmations from being prospectuses if theconfirmation is limited to the information in R. 10b-10.

R. 172(b) says that access is the same as delivery. Hyperlink works.

That doesnt apply to FWP or offers though. Those still need to beA/P by 10(a) prospectus.

R. 173 requires delivery of a prospectus or notice within 2 business daysof confirmation for UW and dealers.

Confirmation of sale is a prospectus.Required under 34 Act R. 10b-10, but dontneed to be accompanied or preceded b/c of notice under R. 172. (R. 173).

Weird thingno need to see prospectus, just receive it (even after purchase).

Release 7856 says customers can consent to e-delivery in which case posting ahyperlink to the prospectus can be enough. Rule 433 says the same for FWP.

Disclosure RequirementAll Material Informationmust be disclosed How to make disclosures depends on the type of offering

Initial Public Offering (IPO)first time issuing securities

7 says what must be included in the registration statement

Look at forms instead of Schedule A (Rules 130, 401) If it is not a shelf offering, must use Form S-1. If shelfS-3.

8 deals with when registration statement becomes effective (sort of)

Although it says it takes affect after 20 days, Rule 473 allows SEC to delayeffectiveness automatically.

SEC makes issuer add language that says if this is to become effective, it isamended to not become effective yet. ResultMust ask SEC to become effective.

SEC can accelerate effectiveness under 8(a) and R. 461.

Completely at their discretion

Dont want to challenge SEC on this.


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Shelf Offeringallows company to have a registration statement waiting for when they wantto offer again. Faster alternative.

Rule 415 controls shelf offerings

Limited to certain offerings. 415(a)(1).

If not an S-3 issuer (non-registered issuer) then there is a 2 year limit.

S-3 Filer must be:

Public Reporting Company

Have been one for at least 12 months

More or less a seasoned issuer.

Rule 430B allows a base prospectus to leave out info and include it in a latersupplement when you are ready for a shelf takedown

Process

File S-3 with SEC as a base prospectus

May go through notice and comment in SEC Declared Effective Wait until market looks good for selling the securities

File a 424(b) pricing amendment then you sell.

Automatic Shelf Offeringno need to wait for the registration statement to be effective. As

soon as the company files the base statement it is effective. Defined in Rule 405

462 says it is effective upon filingno waiting period

Unless SEC notifies of an objection, RS will be deemed on the right form.

430B(a) says you only need to specify a class of securities, not amount/price What must be Disclosed?Reg C (400s) gives mechanics.

Rule 408 requires all material information necessary to make the statement not misleading.

Materiality and Valuation must be disclosed

Materiality is determined by Efficient Capital Market Hypothesis (ECMH)

The price of a stock is the public valuation of all information That means if price changes, the information was important to investors.

Materiality means anything that a reasonably prudent investor would care about, soa change in price means the information was material.

Supreme Court adopts ECMH inBasic v. Levinson

Valuation is determined by discounted cash flows (amount in year one)/(1+discount rate)^years from now Also called Fundamental Analysis.

There are many explicit prescriptions

Forms (S-1 and S-3) S-1 is for non-reporting issuers because they just cant use anything else.

S-3 is for seasoned issuers. Allows more reference to other forms that they havedisclosed on.

Public Companies for at least one year and timely filed your reports. F-1 is an S-1 for foreign companies S-4 is used for M&A transactions

Reg S-K incorporates corporate information.

Reg S-X incorporates a lot of accounting materials. GAAP standards.

SEC can determine more disclosure is necessary after review and comments.

There can be liability for material omissions in disclosure.

Forward Looking Disclosures

Formerly frowned upon by SEC, but now they are being more encouraged because it iswhat investors want.


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Management Discussions & Analysis (MD&A) required.

Public Securities Lit. Reform Act (PSLRA)safe harbor for meaningful cautionarylanguage (actual risks), but not for IPOs.

Upbeat Drafting

Universal Camerashows that SEC hated upbeat prospectuses

Now SEC is less negative, but still dont like it.

Must still disclose material risksneed to be specific: risky or speculative doesntcut it.

Other Rules

Make front and back cover pages, summary, and risk factors in plain EnglishR. 421

Forward-looking disclosure must be based on reasonable dataR. 175 (hard for courts)

Registration Exemptions Private Placement4(a)(2)

4(a)(2) exempts transactions by an issuer, not involving anypublic offerings

What is a public offering?

Ralston Purina says that there isnt a limit on the number of people, they just have to be

informed.

Public does not mean open to the whole world.

Limiting the offer to key employees is not a good enough limitation becauseemployees are just as uninformed as general public.

More sophistication in the limited classless disclosure required.

Release 4552

Who the offereesare matters, not just who the purchasers are. Securities must come to rest with the purchaser. If purchaser acquires the

securities with a view to public distribution, seller assumes risk of possible violationof the registration requirements.

Not strict liability for the issuer here.

Look to see what issuer did/could have done to stop this.

Maybe put a legend on the contract so any buyer might see it.

UW status is deemed if purchased from an issuer with a view to distribution.

Integration

Single plan of financingtrying to finance one item with both sales

Same class of securityone class of stock makes them all fungible. But if PPand S-1 sale are of different classes, they cant be exchangednot integrated.

Easier to make non-fungible debt than non-fungible securities

Debt, just make different interest rates and different terms.

At or about the same time

Same type of consideration received

Offerings made for same general purpose

ABA Position Paper found decisions to rest on 5 factors (based onPurinaand 4552)

Sophistication

Limitation on offerees needs to be based on some level of sophistication

Can give the class of offerees a representative to make them sophisticated Informationmake people sophisticated by educating them in the company through

disclosure Manner

Cant condition the market to make non-sophisticated people want them bysending out a mass advertisement saying only available to sophisticated buyers


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Integrationif you do a private placement contemporaneously with a publicsale of securities, the two transactions are integrated and your private salebecomes an illegal pre-filing public sale.

Redistribution Number of Offerees

Accredited Investor Offerings4(a)(5), Reg. D & Rule 506

4(a)(5) exempts sales that are only to accredited investors when aggregate offering price isless than $50MM (maybe $5MM?)

Accredited Investor = $1MM of net worth or $200k of income ($300k w/ spouse) REG D

Rule 506 operates as a Safe Harbor for private placements CHART ON PG. 215

Rules 504 and 505 are exemptions, but not safe harbors.

Structure Rule 501 provides definitions including Accredited Investor

501(e)accredited investors dont count for the 35 person limit in 505 and 506 Rule 502 provides certain requirements to qualify for Reg D exemptions

502(a)Sixth-month safe harbor of six months

502(b)must furnish registration-type information to non-accredited investors If accredited, no need to send any information

More of a reason to limit to only accredited.

502(c)No general solicitations are allowed.

502(d)Need to take reasonable care to prevent purchaser-resale

Disclosure of non-registration and restriction

Legend

Rule 503 requires filing notices of sale on Form D. Rule 504Chart on 215 Rule 505Chart on 215

Rule 506

No aggregate dollar limitation for sales. 506(b)Can sell to non-accredited investors, but they must be knowledgeable

and experienced and fewer than 35 of them.

506(c) General Solicitation allowed if:

All purchasersare accredited

Reasonable steps are taken to verify accredited status if:

IRS form from last two years & representation of expectations incontract

Wealth: bank/brokerage statementconsumer report of liabilities

Representation of prior reasonable steps by registered broker/dealer,investment adviser, attorney, CPA

For offerees prior to effective date, offeree certification.

Stated in Form D if using 506(c) or not

Not a bad actor

506(d) says what a bad actor is Exchanges3(a)(9)

Security Holder 1 trades a 5% 1 year note for a 9% 3 year note.

Security holders are the same as before and arent paying someone to solicit for them, so nodisclosure required.

Intrastate Offerings3(a)(11)

Release 4434


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an issue is subject to integration with an issue that is interstate.

Doing business within a state requires substantial operations

Residence is not established by presence or representation and the securities must cometo rest in the state. Need to do a lot to ensure that.

Safe Harbor in Rule 147

Six month Integration safe harbor for 4a2 and Sec. 3 exempt deals

Doing business if:

80% revenues/assets/net proceeds derived from that state

Incorporated in that state AND Principle office is in that state

Person resident if: principle office/residence is in that state

9 month in-state resale rule: legend on certificate, stop transfer instruction, and writtenrepresentation of residence.

Offshore ExemptionReg S (Rule 901-905)

Release 4708Registration requirements dont apply to offerings reasonably designed tocome to rest outside of the United States

Safe Harbor ifsecurity is sold in foreign exchange, seller believes buyer is outside of theUS, or resale is made in offshore market.

Type of issuer matters Small Brazilian Firm trading on Brazilian marketeasy offshore case

Large Brazilian Firm trading on NYSE with some American investorsharder

US company can take advantage by selling in Brazil, but will receive higher scrutiny onmethods used to avoid resale in the US.

Publicity

Old Rule: US reporters could not participate in foreign press conferences.

Now 135e has a safe harbor for offshore press releases open to foreign and US press

Offering must be at least partially offshore

Written materials distributed offshore only with a legend Safe Harbor applies to both registered and non-registered offerings.

Release 33-7516 deals with websites Non-US issuer doesnt make offer if:

Prominent disclaimer not for offer in the US and Procedures designed to guard against US sales

US Issuer has stricter requirements Password protection on website

Disclaimers Avoid likelihood of reentry.

Limited OfferingsJOBS Act

Reg Ashort form registration governed by Rules 241-263 and 3(b)

Testing the waters permitted prior to filing under Rule 254 and 251(d)(1)

Offering amount in 3(b) has been increased from $5MM to $50MM so this is used moreoften.

Crowdfunding comes out of 4(a)(6)

Aggregate of $1MM in 12 months

Any investor is ok, but limited to: $2k/5% income if income/worth < $100k

$100k/10% of income/net worth if income/worth > $100k

Registered funding portal required

Info to be provided/filed

1 year restrictions on resale.


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Resales4(a)(1) & Rule 144/145 Creates exemption for all sellers that arent issuers, underwriters, or dealers. Main emphasis is on underwriters because dealers/brokers have their own exemption.

UWpurchases from the issuer with a view to distribution.

For purposes of who is an UW, issuer broadly defined to include control persons

Includes CEO, subsidiary, parent company, director, etc.

10% equity interest is a rule of thumb to make SH a control SH and affiliate of corp.

Control groupindividual is deemed to be a control person/affiliate if he is member ofgroup that has control (family, board of directors, firm with controlling share).

What is distribution?

Courts and SEC have defined distribution as a public offering.

Many things are public offerings but dont count Two Types of Transactions we are concerned about

Control SecuritiesIssuer sells part of its shares to the public and some shares to officersand subsidiaries to hold onto in a registered offering. Then a few years later, withoutregistering, it has its officers and subsidiaries sell to the public when it would not be able to.

Upon redistribution, the seller is an issuer and the buyer is an underwriter.

Ira Hauptbroker sells for account of controlling SH of a company. SH is an issuer as a

control person under 2(a)(11). Makes broker an underwriter b/c selling for an issuer inconnection with a distribution.

Restricted SecuritiesIssuer makes Private Placement to buyer, buyer sells it to the public.

Shares never come to rest, so PP buyer is an underwriter

Sherwoodbuyer buys stocks in a PP with intent to hold on indefinitely. Circumstanceschange and he has to sell the securities2 year holding period considered acceptablebefore Rule 144. Change of Circumstances doctrine now defunct. Release 4552.

Public Resales Rule 144 is a safe harbor for how to publicly resell these securities safely

Definitions

Affiliate = Control person Restricted Securitiesfrom issuer/affiliate not involving public offering: Reg D, 144A,

CE, Reg S, 4(a)(5), 4(a)(2)

Safe Harbor creates four categories of transactions

Unrestricted Securities, Non-affiliatesno restriction

Restricted Securities, Non-affiliatemust meet (c)(1) and (d) if reporting 144(c)(1)current public information by reporting issuer. Issuer has been s/t

reporting requirements for 90 days before the sale.

144(d)Holding period

Reporting Company6 month

If held for a year, then no info requirement necessary.

Non-reporting Company1 year. Non-reporting companies only have to meet (d)

Restricted Securities, Affiliatemust meet all requirements (c) requires current public information for both reporting and non-reporting

(d) holding period (e) limits the amount of the salenot more than 1% of outstanding shares in 3

month period.

(f) manner of salemust be anonymous broker transaction (h) notice of salemust notify commission if >$50,000 or 5000 shares.

Unrestricted Securities, Affiliatedo not have to meet holding period requirement


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Economic Reality Test: If buyer doesnt take on real risk of the stock (e.g. Issuer pledges toindemnify buyer in case of any losses on resale), then this is really a public offering by theissuer

If outside of Rule 144, you can argue you dont meet control person or that you held it for 2 years. Private Resales4(a)(1.5)

Private Placements by their terms only apply to issuers, so cant be used on resale.

However, if you avoid underwriter status by avoiding a distribution (i.e. doing a privateplacement rather than public offering)then you meet 4(a)(1)

Rule 506 doesnt completely apply, but you could do an equivalent transaction withoutadvertising it to the public.

Private resale safe harbor is Rule 144A

Allows resales to Qualified Institutional Buyers (QIBs) after an exempt placement. QIB

Corp. that owns or invests more than $100MM in securities of non-affiliates

Banks and savings & loans

Registered dealers ith more than $10MM investments in non-affiliates

Sales by dealers are covered in (c) and are generally ok.

Sales by person who is not issuer or dealer are not deemed an UW if:

Offers are only to QIBs What you can rely on

Most recent publicly available financial statement (of last 16 months)

Info in forms filed with SEC

Public info in Securities Manual

Certification by CFO or other executive stating amount of discretionaryinvestment company has.

Take reasonable steps to inform of restricted status of 144A exemption.

Not fungible

Non-fungibility requirementsecurities cant be listed nationally at time ofissuance because it cant be fungible with publicly traded securities.

Necessitates debt securities. Reasonably current information on issuer upon request by purchaser.

144A(e) provides integration safe harborif someone sells to public, it doesnt destroythe entire chain of transactions

How all of these alternatives work on private resale market

506 is what is most commonly used, but problem is if one person sells to the public, theentire transaction loses its exempt status. One big integrated transaction.

144A would take care of the integration problem, but then it is limited to QIBs

144 may work if issuer sells to employees and they wait a year and start a market. Norestrictions then, but the problem is if the original seller is affiliated.

Securities Act Liability

Public Offering Liability11

Section 11 gives liability for inaccurate content of registration statement

Applies to a lot of people

Anyone who signed

Directors or partners at time of filing

Everyone named in registration as about to become director or partner

Any expert who has prepared or certified part of the registration statement (wrt hisstatement)

Every underwriter


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Strict Liabilityfor material misstatementsand omissions on registration statement at timeit becomes effective.

No liability under Sec. 11 for preliminary prospectus.

Materiality defined by Rule 405 Not liable for systemic world events (War with Syria tomorrow!)

In re Adams Golf(2004) involved golf club company failing to disclosegraymarket had been started for its clubs which would decline future revenue.

Announcement in press release didnt cause price to drop of stock.

Helps prove immaterial under EMCH, but there could be other reasons.

Proving that info is immaterial saves you from liability.

Escot v. Barchris discusses materiality through the various lies told by Barchris Earning Statementsdiscounted cash flow to show actual earnings and the value of

the difference. Percentage differential.

Backlogorders that cannot yet be filled. Lying would show increased comingcash flow in the future.

Failure to disclose officers loans outstanding and unpaidconflict of interest

Failure to disclose use of proceedsreally paying bonuses instead of investing.

Defendant must show non-causation under 11(e), whereas in 10b-5 plaintiff must makeout causation.

Publicly available information does not normally have to be disclosed.

May have to disclose special risk to your business if something that is publicknowledge happens

Sufficient to say that the risk is dependent upon the price.

Bespeaks Caution Doctrinea court may determine that inclusion of sufficientcautionary language in a prospectus renders misrepresentaions and omissions containedtherein non-actionable.In re Donald Trump Casino. meaningful cautionary statements make forward-looking statements not create

basis for fraud claim if dont affect total mix of info provided to investors.

Cautionary statement must be specific, so you cantjust include every risk . Including too many makes it all meaningless. Vonage.

R. 175 and 1995 reform make forward looking statements more protected.

Due Diligence Defense

Issuer has no defense for misstatements.

Expert Expertized Portion of the RS

Reasonable investigation that provides reasonable ground to believe thestatements were true

Ex. Audited financials, engineering reports, oil reserves Non-Expertized Portion

Reasonable investigation that provides reasonable ground to believe it is true

Non-Expert Expertized Portion of RS

Show you had no reasonable ground to believe it wasuntrue Non-Expertized Portion of RS

Reasonable investigation that provides reasonable grounds to believe it is true.

Reasonable investigation is a sliding standard based on your involvement. Managers andunderwriters are very involved. They can delegate this task.

Only those who purchased in IPO or directly from issuer can sue under Sec. 11, not thosewho purchased in the trading market.


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Damages are in 11(e)Difference between amount paid for security (not to exceed IPOprice) and a number of variable things.

10b-5 requires fraud, but gives higher damages.

Choose both. Illegal offers and Sales12(a)(1)

If you mess up the registration statement process, this is where your liability comes from.

Strict liabilityfor not following the correct procedure.

Recission liabilitybuyer from illegal offer/sale can get their money back.

Basically a put option for the buying price. 2 types of options

Putright to sell at a certain price

If trading at lower than the put, you can make money by buying a stockthen selling it at the put price.

CallRight to buy at a certain price

If trading at a higher price, you can make money by buying at the callprice then reselling at market price.

Requires direct link between issuer and purchaser.

Cannot fix a 5 violation after the fact. Once violation happens, liability sticks.Diskin.

Who is the Seller? Broad conception of who is a seller.

Dahlinvestor in oil wells (who doesnt own any of these oil wells) recruits friends tocome buy interests from Pinter. Dahl (investor) is an expert, so he is carrying out the diligence for all of his friends

and says there are productive wells.

Wells end up not producing after Pinter sells to Dahls friends and friends suePinter Pinter sues for contributionwins.

Nothing in definition of sell requires passing of title. Offers includesolicitation.

Seller must somehow benefit himself through the sale, but doesnt have to be

the former owner of the securities. Cant only be interested in benefit of buyer.

No commission is not a conclusive non-interest. Can be liable if advancing yourown or owners interest. Rejected Substantial Factor Test.

Seller Liability for Prospectus12(a)(2)

This provision has been somewhat gutted by Gustafson, which says this only providesliability to original issuer and not subsequent sellers with individual prospectus misstatement

Gustafsonsays that prospectus is only document of wide dissemination, so offer letter toan individual doesnt count.

THIS IS WRONG. But we are stuck with it.

Makes it so 10b-5 is way more common.

Allows previous sellers to sue up the ladder. Purchaser 5 cant sue issuer because no privity.

However, he can sue purchaser 4 who can sue purchaser 3, etc. If purchaser 3 made the material misstatement, liability stops there.

Coverage is broader than 11final prospectus, FWP, preliminary, oral communication, etc.

Also covers exempted communications and info from people who are not the issuer oraffiliates.

Same standard of care as 11Sanderssays reasonableness requirement is same asreasonable investigation.

Aiding and Abetting15

Provides liability for control persons if they did not have reasonable belief that statementswere not true.


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Much harder to bring now Anti-Fraud17

Almost the exact same as 10(b) of the Exchange Act.

No private right of action though.

Cort v. Ash test:

Is P of class meant to be protected by statute? Is there evidence of legislative intent?

Would private right be consistent with underlying purpose of the overall scheme of

statute? Is cause of action a matter of traditional state law, or a concern of the states?

Touche Ross v. Redingtonsays legislative intent is most important factor.

Only applies to offers/sales while 10(b) also applies to purchases.

SEC can do anything under 10(b) that it can do under 17, plus 10(b) has private right ofaction.

Willful Violations/Criminal Liability24

Generally use mail/wire fraud to put someone in jail because those only require deceptive actwith use of mails (not even materiality)

Securities Act is much harder, must prove willfulness

Willfulness only requires that the person know what they are doing, not that specificinstrument used is a security. U.S. v. Brown.

Need specific intent to commit the fraudulent act.

Note: SEC has no criminal prosecution power, but can seek civil penalties and transfer casesto the Attorney General for prosecution.

Pre-Enron AG was reluctant to take Securities Cases

Post-Enron they are eager.

If you do a deceptive act, you know lying is wrong, even if you dont know its against the

lawconsidered willful and knowing.


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Exchange Act of 1934

Registration/Reporting Requirements of Public Companies How to become a public company

Public Offering 15(d), Reg 15Dif youve gone through registration process of SecuritiesAct you must file periodic reports under Exchange Act (same effect as 34 Act registration)

Like 13(a), and 12 there is no private right of action here if company fails to file.

Sufficiently Large12(g)(1)

Shareholders of record for a single class of security of more than 2000 or 500

unaccredited investors AND Assets > $10MM

Elect to be soRegister with Form 8-A

Listed on an exchange12 and 6 What is required of public companies?

Reporting

10k annual report that is available to public

10Q quarterly report

8k for certain material events

Substantive requirements for how the company must conduct itself

Formerly only disclosure, but now substantive requirements as well Sarbanes Oxley introduces a lot of substantive corporate governance.

13(a) requires periodic reporting, by not doing reporting correctlyviolate 13(a)

No private right of action under 13(a). Any right of action must come from 18. 18(a) is exclusive remedy for violations of 13(a).In re Penn Central

If no material misstatement or omission, private litigants dont have remedy for

purely technical violation here. (Different than 12(a)(1)).

According to recent decision against JP Morgan, 13(a) can be violated by making inadvertentwrong disclosure. A little overly aggressive.

13(b) requires certain record-keeping functions. Still probably no private right of action.

SEC said they wouldnt go after bookkeeping alone, but that is what just happened to JP

Morgan Chase. 13(l) is SOX real-time reporting requirement

Certain material events must be disclosed using Form 8-K.

13a-11 has safe harbor for failure to file for certain events. 18(a) is how all of these disclosure requirements would have to come by private suit.

Provides cause of action for false or misleading statements in 34 Act filings

What are the elements?

Purchase or sale in reliance on defective filing Actualpurchaser of seller, no someone who would have bought but for the

defective statements

Price must be affected by defective filings

Use ECMH?

Good Faith defenseacted in good faith and w/o knowledge that filing was defective

Securities Fraud (10(b) and Rule 10b-5) Rule 10b-5 is most important liability in Securities Law Prohibits fraud in connection with the purchase or sale of any security. Insider Trading

ClassicCady, Roberts & Co.

Somebody that is an insider leaks information to an outsider than he isnt allowed to

know

Do not need a duty to the corporation.


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Test Relationship giving access

Inherent unfairness of unequal playing field.

Texas Gulf Sulpher involves geologists who know that they had a big find.

Bought a lot of securities when company made misleading statement that it didnt

have a big find because they knew that it did. Duty to disclose or abstain from trading when information is likely to have

effect on price.

Duty applies to anyone in possession of material inside info Economics of Insider Tradinginsider trading will depress market prices and keep outsiders

out of the market because it is a lose-lose for them.

Misappropriationget information from some relationship as vendor to the company(financial printer or lawyer) and use it to insider trade.

ChiarellaFinancial printer cracks code on documents and trades on it

Court said this wasnt an insider, so it didnt count However, now that is against the rules.

U.S. v. OHaganlawyer insider traded, but not an insider because he wasnt the lawyeron the case. Saw it on a partners desk. Misappropriation theory adopted.

OHagan had duty to law firm to not misappropriate information

When he misuses info he breaks his duty to law firm in connection withsale/purchase of security.

U.S. v. CarpenterWSJ writer misuses power of article changing prices to trade beforepublication. Same thing.

In Connection With Requirement

Materiality will satisfy in connection with as long as there is public dissemination

Semerenkoexpressly relies on the ECMH to say that if price moves we have materiality andin connection with

If there is a price change in the market, someone is buying or selling based on a different

price than they would if information was correct. Market integrity and broker integrity are suitable grounds for 10b-5 suit.Zandford.

Breach of fiduciary duty in trying to screw SH does not necessarily come under 10b-5,especially if there is another law covering that specifically. Santa Fe(short-form mergersituation with false valuation).

Reliance and Causation

Reliance requirement doesnt come from statute, but common law fraud requirement.

Affiliated Ute Citizenin face to face transactions, if there is material misleadinginformation then there is no proof of reliance required.

Defendant can rebut the presumption of reliance

Has been extended beyond face-face transactions including fiduciary duty claims

Duty to disclose only applies to insiders sale, not all other peoples losses who are trading. Too speculative to say other people wouldnt have traded if insider abstained or

disclosed.

Damages are limited to people he actually sold to or purchased from.

Basic v. Levinson adopted ECMH and Fraud on the Market Theory

FOTMTEven if purchaser didnt rely on actual statement made, but relied on publicprice, reliance and causation are satisfied.

Rebut the presumption by showing P knew a statement was false or by saying statementdidnt change the price because no one believed it.


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10b-5 Elements

Fraud

Scienter

Inferences are allowed. Motive is taken into account by courts (show incentive)

Recklessness generally counts Corporate Knowledge

Agent making statement for company must know statement is false or berecklessly negligent in not finding out it is true for liability to be imputed on

company Minority says if one agent knew of falseness that suffices

Materialitywhat a reasonable investor deems important Deductionuse net present value to find out what information is worth.

Inductionlook at how the market responds. ECMH

Reliance

Fraud on the Market Theory

Rebuttable

Becomes corollary of materiality

Who relies on fraudulent price?

People who purchase between fraudulent announcement and revelation offraud

Dura says P must show economic loss so that price inflation isnt enough, but

you need a drop (seems wrong because you paid too much if price is inflated)

Causation Transaction causationfraud induced transaction

Loss causationfraud caused the actual loss complained of

Damages

Bastianis bad decision by Posner which makes it so lying is profitable. no harm, no foul However, expected value of lie makes it so they can lie and if it is just a bad market,

they win. By any person

In connection withdiscussed above

The purchase or sale

Blue Chipmust actually purchase stock. Cant say you would have if the information

wasnt falsely negative.

Wharfgetting securities in return for services is still purchase

Of any security

Documents

Securities Regulation Spindler Fall2013 Kreshover