INTRODUCTION

A. A glossary of terms and Introduction:

1. Broker/ Dealers - There are essentially two markets in this country: a. The NYSE is an auction market . It is a broker market, in which the large companies act as brokers. b. The NASDAQ on the other hand is a dealer market . In these markets, those companies function as dealers. Registration of Securities vs. Registration of Transactions: You register an offering, not a security, and not a company. Issuer: is the company or enterprise that issues securities. They sell securities to the public. They can be any sort of entity, and need not be a corporation. Underwriter: are the middlemen in the securities business. They buy from the issuer and sell to the common person. Initial Public Offering (IPO): [an IPO can only be done once. It is the first time that an issuer offers securities to the public] Public Offering: [any time that the issuer offers securities after the IPO, it is a public offering.] Primary Offering: [likewise, every offering that occurs after the IPO is a primary offering] Secondary Offering: [Secondary distributions are done by someone other than the issuer, (generally, statutory underwriters and affiliates under 2(a)(11)), but whom still must be concerned with 5 they must register, or seek exemption under 144, 4(1), or Reg A. Such distributions should also be distinguished from secondary trading which occurs only after these securities have come to rest in the public.] It is an offering only by insiders, but not by the company. When Bill Gates sells MSFT stock, it is a secondary offering. Microsoft the company cant ever do a secondary offering. Secondary Trading: has nothing to do with the secondary offering. Secondary trading is merely the trading of securities in the open market by the average person (the securities have already come to rest in the public. Unlike most of the offerings above, it is generally exempted from regulation.

2.

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7. 8.

9.

10. Municipal Bonds: a.

General Obligation bonds : issued by a state, municipality or federal gov back by full faith and credit (taxing power) they are treated as cash by businesses because the entire government is behind them if the government cant pay them off you have bigger problems then the debt. Revenue bonds : are not backed by full faith and credit, they are backed merely by the project the bonds finance. This permits the government to do many things at attractive interest rates without bankrupting the government if the project should happen to fail.

b.

B. A Brief History: Capital (money) was never raised from the public through most of history until the war bonds of the civil war. Prior, you would borrow money for ventures from large merchant banks. Back in the day, securities buyers had to beware they were limited to common law redress, whereby there was almost no remedy. Some states began to enact laws to protect investors, but they were not effective. The 20s were a time of great prosperity, but also great fraud. The big crash resulted, and federal regulation of securities followed.

C. The Big Four Securities Laws

1.

The Securities Act of 1933 [is a consumer protection statute that rose from the ashes of the 29 crash the main purpose of the act is to mandate disclosure (through registration, or alternatively, through carefully carved exemptions therefrom) to investors so that they will be able to make smart informed decisions. In addition, the act mandates certain disclosures be made to the SEC] : The basic idea after the crash was that investors had lost confidence in the market because of the 20s. 1) The 33 Act is a Consumer Protection Act. It deals with the selling and issuance of securities. 2) The Primary purpose of the 33 act is disclosure. The theory is that if you sell securities with full disclosure, then investors will be able to make smart, informed decisions. 3) A secondary purpose is that disclosure is forced to the SEC. The Securities Exchange Act of 1934 : [Unlike the consumer protecting 33 act, the 34 act is a regulatory statute. In addition to creating the SEC, the 34 Act also regulates multiple facets of the securities industry: exchanges, broker dealers, public companies, insiders, tender offers. Likewise, it provides for various anti-fraud provisions]. It was far different from the 33 act. It is regulatory statute with a different philosophy it actually tells brokers and dealers how to run their businesses, how people should conduct their affairs. 1) The 34 Act created the SEC, the single most important element in the restoration of investor confidence. 2) The act regulated how the markets were run. They also regulate the broker/dealers that function in that market. The Investment Company Act of 1940 [intended to target pre-crash abuses of investment pools, the 40 act regulates investment companies. This regulatory statute mandates registration and carves exemptions therefrom, and dictates organizational and operational rules and regulations.]: regulates mutual funds (pool investing) which had been one of the larger abuses during the 20s. The Investment Advisors Act of 1940 [Subject to exceptions, it regulates anyone who, for value, gives investment advice as to the purchase and sale of securities. The Act is a regulatory statute, most notably prohibiting contingent fees based on performance.]

2.

3.

4.

D. A note on Blue Sky Laws: Blue Sky Laws vary tremendously from state to state. Unlike SEC review, some states have merit reviews of your offering, above and beyond merely requiring disclosure: they have a fair, just and equitable standard whereby they decide whether to approve an offering based on the company, who is involved, etc. They also may care if an insider paid too little for stock, dilution issues, or loans to officers.

1. The real difficulty arises when you try go effective with both the SEC and the Blue Sky Jurisdiction at the same time (which you obviously need to). 2. In 1996, Congress passed the National Securities Market Improvement Act: preempting from state review a variety of covered securities, which includes those traded on the NASDAQ, NYSE, and AMEX.

DEFINING SECURITY
E. Intro : The 33 and 34 act all rely substantially on securities, but barely define it. 1. If the thing in question is not a security, then right off the bat the federal securities regulations have nothing to do with it, and cannot regulate it. 2. Likewise, plaintiffs cant get the protections of the securities act and the remedies available therein unless the thing is first a security. 3. Back in the day, people pooled money for ventures. They got people to buy stock in the actual thing that was the venture (i.e. ship) and then they got a share of the profit later. 4.

Debt vs. Equity:

1) Debt: comes in three main forms, but the only real difference is the term of maturity notes (shorter term of 3 years of less), debenture (medium term of 3-10 years), and bond (long term of 10-30 years). They may or may not be secured. Some debt is a security, some is not. 1) Debenture : is merely the instrument that gives debt its term. 2) Equity: A share of ownership is equity. 1) There is both preferred and common stock. They can also be convertible as between the two (or into debt). 2) A certificate of designation is a debenture for preferred stock it gives it its term.

F.

Interpreting the 33 Acts Definition: The first place to start any analysis is the definition in 2(a)(1): The term security means any note, stock, treasury stock, bond, debenture, evidence of indebtedness investment contract . 1. Investment contract has become something of a catchall. Initially, the Howey Test was to determine what an investment contract is. But later cases like Forman applied the test to stock or any security being tested, reasoning that if it didnt meet an investment contract analysis, it wouldnt be a stock or whatever either. Any instrument, no matter what it is called, is a security if it meets the Howey Test. If it does not meet that test, it still may be a security, but you have to justify it in some other manner .

2.

Note that simply because something is called a certain type of enumerated security from the definitions in 2(a)(1), it isnt automatically a security in Reves the court notes that the phrase any note should not interpreted literally to mean any note, but must be understood against the backdrop of what Congress was attempting to accomplish in enacting the Securities Acts.

a.

Similarly, the court in Marine Bank noted that Congress, in enacting the securities laws, did not intend to provide a broad federal remedy for all fraud. So we cant catch too much in the net.

3.

SEC v. W.J. Howey: The Howey test, simply put, is that a security is any contract, any contract, transaction or scheme whereby a person (1) invests money or something else of value with an expectation of profit, (2) in a common enterprise (3) [predominantly] from the efforts of others.
a. The basic idea is that you give money to someone with an expectation of a return on that money based mainly from the efforts of another person or persons. b. Investment contract involves a flexible rather than a static principle. c. It is irrelevant that the shares in the enterprise are evidenced by formal certificates or by nominal interests in the assets employed by the enterprise.

d. The Howey company wanted to sell securities in their orange grove but they didnt want to register them. They didnt want the hastle or the consumer protection availed to the investors. So they divided up the land and entered into management agreements with investors saying Howey would manage their plots and sell the oranges and then they get a share of profits. The SEC brought the case even though nothing bad happened (other than not registering). e. The SEC claimed it was an investment contract: investors were giving money in exchange for a pro-rata share of the grove. They were taking something of value in exchange for an expectation of a profit. f. Note that any of these things can be met simply by offering them (for instance, if youre offered the management agreement in Howey, it satisfies the test it need not be mandatory).

4.

Tweaking the Howey definition: a.

Expectations of Profit - The Economic Reality / Investment Consumption Test : [Aka the investment consumption test or common sense test, plays into the Howey test, acknowledging that the reality of what is an investment in form may not be in substance [Forman] Investors may be merely purchasing goods or services for consumption, as an incidental but necessary facet of a transaction etc., but surely not for investment.] The investor cannot be merely purchasing a commodity or some consumable service. [but argue economic reality was possibly overruled in Landreth.] United Housing v. Forman: reject nomenclature in favor of economic reality substance governs over form.
1) Co-Op city was a low income housing development where you had to buy shares in the development company to get an apartment. 2) The 33 Act does say any stock, but the court said simply calling something stock doesnt make it a security. Its not a security because:

a)

The Economic Reality or common sense of the situation was that they werent investing, they were just buying an apartment. The tax deductions you get off the home arent enough to satisfy profit. The purchase of the stock was just a requirement to get the house. They were not really iven the rights that usually come with stock, they were not transferable to a non-tenant, could not be pledged or encumbered, had no voting rights. So we can take a look at a situation and see what is really going on.

b) It fails the Howey Test: The court applied Howey and found that there was no expectation of a return on investment as profit. (1) even if someone did invest in the venture for profit, any . appreciation on the investment would be on the apartment, not on the stock in question.

International Brotherhood of Teamsters: a. noncontributory compulsory pension plan is not an investment contract, because of the economic reality the employee sells his labor to make a living, not as an investment, and it is the employer who makes the contributions to the investment, not the employee. b. The profits you get are also not dependent on the efforts of others. c. Receipt of the fund had to do with external requirements, not success.
b.

Efforts of Others - SEC vs. Life Partners:

1) Terminally ill patients who had life insurance would sell it to people who would then become the beneficiary. The SEC claimed this was a security. Was it? a) It was clearly a scheme b) People were investing money c) The were pooling money, so it was a common enterprise. d) They expected profit 2) But the venture did not involve the efforts of others. After the investment was made, Life Partners did nothing to increase the value of the investment. They just waited for people to die. 3) Note that the solely on the efforts of others language has been read out to mean predominantly based on the efforts of others . [SEC v. Koscot Interplanetary] 4) A note on LLCs and Partnership Interests : Whether an interest in one of them is a security depends largely on the efforts of others test. This generally boils down to how much input each member has to defeat the efforts of others test. a) General partnerships are not securities, since every partner has a right to manage. (1) Of course, if you set it up so that some general partners are really passive investors and they cant possibly manage without letting others do the work (perhaps because of geography etc.), then its still a security. [Koch v. Hawkins].

b) Limited partners in LLPs are security interests, since they have no management voice. c) LLC memberships are security interests in the same way since there is no management interest. d) But See Steinhardt v. Citicorp: limited partnership agreement found to not be security, since the agreement granted enough rights to the members such that they were no longer passive investors. c.

Commonality The basic idea of commonality is that the investors are dependent on either each other or the promoter for a return on their investment, that they are in the same boat, that they all lose or make money from the efforts of the manager / promotor. Wals vs. Foxhill: individual bought timeshare in Fox Hills Villa condos (which is a big golf course in Wisconsin that he bought a week in February at, which means he doesnt really wanna play golf there).
1) A share of a week in a condo is not going to generally be a security, but these a tradeable from a pool of other timeshares, and that makes it more of a security. a) There is an investment whereby they expect profit b) The value depends on the efforts of others (it needs to be maintained, advertised etc.) c) But is it a common enterprise? 2) Vertical vs. Horizontal Commonality: Note that the Supreme Court has never spoken to the circuit split on commonality. a) Horizontal: at least two investors must be in the same boat you make money together or no one makes money. Howey easily had horizontal commonality since they all made money at the orange grove together (or lost together). This is the toughest standard for commonality. (1) Here, if your timeshare isnt in the general pool, you can buy it and sell it on your own and you are independent no horizontal commonality. The guy next to you is irrelevant. (2) The problem of the individual investor : if the nature of horizontal commonality requires a second investor, how can you ever have a security if there is just one investor? The solution is that you ask whether there would be horizontal commonality had there been a second investor, but looking at the investment as is (you cant just say split it) in other words, you need to consider whether the investment being offered could accommodate other investors if they were around. b) Vertical: it is enough to show that the success of the promotor / owner / developer and the investor are tied. (1) Strict view: vertical commonality doesnt exist unless the success of the promoter is contingent upon the profit of the

investor they need to make money or lose money together and in proportion to one another One way to see it is that it needs to be the actual return on the their investments. Moreoever, the promoter cannot have no downside risk (or else its just broad). (2) Broad view: as long as the promoter gets some benefit out of the arrangement (other than the initial investment obviously), there s vertical commonality. This is the easiest standard for commonality. Typically, this is a situation where promotor gets some benefit when investor makes money, but doesnt lose money with investor. For investor, it may be a return on their investment, but for the promoter it may simply be residual income. 5. Other cases: a. Virtual Stock Exchange Case where the court said that simply called something a game doesnt mean they are not offering securities. b. Smith v. Gross: sale of earthworms where seller promised to repurchase the reproduced worms and to market them to farmers deemed security. c. Koscot: sale of participation in a pyramid scheme where the seller conducted meetings and buyer received a commission for each person brought into the scheme deemed a security. 6.

BUT Better Regulatory Scheme or Adequate Protection Elsewhere? [where consumers are otherwise protected (by, as here, Banking laws), registration would impose an onerous yet unnecessary burden on issuers. Likewise, that regulatory scheme may be more effectively tailored to regulate the security in question. See Matassarin, Teamsters]
Note Teamsters v. Daniel and Matassarin v. Lynch: the SEC laws may not apply to something (so you can pass Howey but still escape categorization as a security) where there is a better regulatory scheme out there. These cases dealt with whether pensions were securities, but the court concluded that ERISA, the federal law that regulated pensions was better suited to deal with pensions.

7.

Uniqueness [is a factor that plays into Howey analysis: where an offering has a uniqueness such that no other investor could take part in it, it may be improper to label it a security, lest the 33 act overreach and serve as remedy for any and all fraud in any transaction. [Weaver] Similarly, requiring registration for such a unique offering may simply be inefficient the dissemination of information requirements of the acts are justified by economies of scale that do not exist in unique transactions. ]
Note: Marine Bank vs. Weaver CDs in banks were being questioned as to their status as securities, but the S.C., reinforcing the regulatory scheme notion, said banking laws were better to control this. Also, the court said there was a unique business relationship between the parties, so no security is involved, basically the transaction had unique attributes such that no other investor can share in it or be party to it. Uniqueness works like this: the arrangement has different values to various investors, and is therefore not suitable to public trading. b. But the case did fumble in that they said it wasnt a security because it didnt involve a prospectus and werent publicly traded. This has nothing to do with the test for a security. a.

8.

Real Estate as a Security: The standard sale of real estate is not a sale of a security. Investment contracts may be present, particularly in the sale of condos where the unit will not be occupied by the purchasers.
a.

SEC Release 5347 : ANY the following will aid in a condo (purchased directly from a developer) being an investment contract: 1) emphasis on economic benefits derived from managerial efforts 2) offering of participation in a rental pool arrangement 3) unit must be offered for rental at any time in the year, use an exclusive rental agent, or otherwise restricted in occupancy or rental of the unit. Hocking v. Dubois: broker helped Hocking buy Hawaii condo, involving an optional rental pool that he took part in, and he let someone manage the property for him. The court analogized the entire situation to Howey except that Hocking purchased the condo from another owner on a secondary market, not the developer themselves. 1) It was purchased as an investment with an expectation of profit 2) The rental pool creates horizontal commonality, the participants pool their assets and make money together. We need not get into vertical then. 3) The big problem is the efforts of others test, and it depends on the facts as to how little control he had over the investment. The general partner limited partner dichotomy provides guidance. 4) Everything must be offered as one package the elements of the test are NOT met if you can go out and get the rental pooling or management agreement separately.

b.

9.

Notes as a Security: Notes are tricky and may require a separate test To hold that a note is not a security unless it meets a test designed for an entirely different variety of instrument would be inconsistent with Congress intent to regulate the entire body of instruments sold as investments. [Reves]
Unlike stock, which is by nature something Congress intended to regulate, notes can be for investment (which we wanna regulate) and commercial (which we dont). So a distinction is made between commercial notes and investment notes. a.

A commercial note IS NOT a security . Commercial notes are generally short term (30-60 days), but just because a note is short term doesnt make it commercial. Common commercial notes are bank financing, commercial asset financing, inventory financing they are not for investment so it fails Howey and the investment / economic reality test. An investment note (debenture, bond etc) is a security .
To distinguish between the two, Howey is still the relevant inquiry, but we also rely on The Family Resemblance Test [Reves v. E&Y - the 33 Act defines security to expressly include any note, but only investment notes demand protection of securities laws commercial notes are not securities. The test therefore sets forth four prongs to determine whether commercial or investment (and therefore security or not). Reves v. Earnst and Young: Reves tells us whether the security in question is a commercial note or an investment note. If its an investment note, its a security. If its a commercial note, its not.

b. c.

Term of the note: A short term duration however, is not dispositive, but it is indicative. Commercial notes are generally short term in nature, and investment notes are longer term. (9 months will establish presumption of note ) - the presumption can be rebutted by looking to the other prongs of the family resemblance test and being classified as a commercial note). 1) Motivations of the (BOTH) parties: is the buyer interested in the profit from the note as an investment (security) or is it merely some commercial purpose like short term financing (not security), for the seller is it more a particular commercial or consumer purpose (not security), or is it being offered for general business purposes (security). 2) Plan of distribution also comes up here - to whom are you selling the notes. If it is to the general public, it is almost always an investment note. If there exists common trading for speculation or investment its more likely for security. If it is more to people in the business of financing short term assets, its more likely a commercial note. 3) The Commercial Expectations of the Public: what would other people consider it? If it is advertised as investment, it may be a security. 4) Existence of some better regulatory scheme to provide protection: this is generally less important than the others d. The court said notes in commercial lending, those secured by a mortgage on a house, assignment of accounts receivable are not securities. 10. Sales of 100% ownership: It used to be, under the sale of business doctrine [had previously acknowledged the economic reality that incidental transfers of securities in a sale of 100% of a business were not securities offerings within the acts, but the doctrine was rejected in Landreth, where the court chose form (stock is stock over substance)] that if you sell 100% of ownership interest in a business, it is not a security you cant be relying on the efforts of others since youre the only owner. a.

Landreth v. Landreth: The Supreme Court rejects the sale of business doctrine, and said, whether 100% or not, youre still buying stock and under 2(a)(1) thats a security. 1) But most lawyers dont see this as a repudiation of the economic reality test of Forman.

11. Note that we check the status of a potential security at its inception: you cant change your involvement in a venture such that it becomes a security. Of course, if you try to set it up with plans for it to become one, then its still a security. 12. Creation of a Separate Security [securities can be created in interests that would otherwise not themselves be securities scotch is not a security, but if you put the scotch in trust and sell interests in the trust, youve created and sold securities (provided such scheme otherwise satisfies Howey]: If you buy a thing, it is not a security. But if you set up a trust using other peoples money to buy that thing and hold it, the interests in the trust are a security. Purchasing many stocks with a trust is also known as a mutual fund . This is merely the creation of separate securities. Basically, if you take something that is not otherwise a security and sell instruments or interests in it, then a separate security has been created.

13. Examples: a. Suppose you buy a McDonalds and hire people to run them. Under Howey, this is a security: so when the case came out all franchises had to change the way that they operated, such that everyone had to now be owner operators. Once the owner operates, you fail the efforts of others test. b. Commodities are not securities, they are just commodities. c. A sale of 100% of the assets in a company is not purchase of a security.

d. Real Estate transactions generally do not involve the sale of securities, unless there is something more. Buying a house is not purchasing a security. But with something else, we need to look to the expectations of the parties (are they investing in a business enterprise), is there commonality, and are they relying on the efforts of others. e. Suppose Jaguar told customers to put down a deposit to get a special model car because otherwise they cant produce it for you, and collectors are waiting to pay far more than what you put in. 1) Its a scheme, there is an expectation of profit (assuming at least one person will sell it after they get it), and it sort of meets the efforts of others test since they are building the car with your money. 2) BUT the flipside is that perhaps you can argue consumption rather than investment. Moreover, the appreciation in value is to the car, not in Jaguar stock. Jaguars efforts dont change anything, they just make the car, and thats what they do. The fact that the market makes the car more valuable does nothing. f. Suppose instead that Jaguar says forget giving you the car, just send us the money to build them, and well send you much more in return when we sell it to collectors. Theyve just converted the transaction into a security.

g. Law firm offers partnership to Slick, requiring a capital contribution of $35,000. Slicks income will be based on his productivity (hours). This appears to meet the efforts of others test (he makes a substantial amount of profit from the other guys [predominantly efforts of others]), except that there is not really any investment here: his profits come from his own efforts, not from the $35,000 he put into the firm.

REGISTRATION
G. 5 of the 1933 Act Registration Requirements: [is the entire essence of the 33 Act is the 5 requirement that no security may be offered without registration, and in a sense the rest of the act is simply commentary and exceptions to this section.] 1. It shall be unlawful: The SEC has tremendous power to prosecute you 2. For any person: Person under the securities act is a term of art meaning anything from human being, entity, trust etc.

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3. To use any means or instrumentalities or interstate commerce: back in 1933, there was a huge fight over the constitutionality of the 33 Act. To survive the challenge, youll see inserted clauses for interstate commerce. 4.

To offer to sell or buy, through the use or medium of any prospectus [Conceptually, a prospectus is merely any document that provides disclosure of information to investors. The Supreme Court doesnt seem to agree however (See Gustafson, limiting definition of prospectus (and 12(a)(2) recovery) to those in registered offerings). You cant sue on preliminary prospectus, but SEC provides comments and you revise until final gets distributed to all investors] or otherwise, a security, unless a registration statement [the two part document called for by 5 for registered offerings, consisting of two parts the main bulk is the prospectus, and the second is largely SEC housekeeping stuff] has been filed.
a. You cant offer or sell a security in this country unless a registration statement has been filed with the SEC. b.

Note: The SEC has no merit review authority they only care (in theory) that everything is disclosed. In reality they have tremendous discretion in their review. Nor do they verify the statements that are made when you register.

H. The Registration Process Itself : Registration is expensive and time consuming. 1. There is no such thing as a registered security you register the offer, not the security. a. If Microsoft files a registration statement, offers stock, then buys back the shares, and then decides to offer those shares back on the market, youll need to file another registration statement as to the new offering. 2. There are 3 basic forms: S-1, S-2, S-3. S-4 is for mergers. S-1 is what everyone who cant fit into the short forms that are used only for established companies. 3. The registration form itself is a series of questions, but they need to be answered in long form. The entire idea is disclosure you dont just fill in the blanks. a. There are two parts: Part I and Part II. 1) Part I is the bulk of the statement (90%). It is used to later produce the prospectus to be distributed. 2) Part II is just housekeeping for the SEC. b. Producing the form itself can take anywhere from 6 weeks to 3 months, and involves underwriters counsel, issuers counsel, and the accountants. Issuers counsel coordinates the entire thing. 4.

The fundamental tension in drafting registration statements is that you must disclose everything and be truthful, but you also want to sell the securities. Finding the balance is rather difficult. It also cannot be too long, and overdisclosure is counter to the purpose of disclosure.
The registration statement must also be written in a simple manner (to the readership of the NY times about 10th grade), avoiding jargon and legalese.

5.

6.

The standard for drafting is not truth the standard is two fold :

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a.

The statements cannot be materially misleading in the totality of the registration statement: even if something is technically true, it can still be misleading. Anything material must be included. You cannot omit any material which would make the registration misleading.
You cannot rely on rely on management to provide you with the truth. You need to investigate.

b. c.

7.

Process: The statements are prepared and finally submitted electronically via EDGAR (electronic data gathering and retrieval system). Then the SEC reviews it, and they get back to you with comments in a comment letter . You respond by filing an amendment, and this can go back and forth for a while. The result is the prospectus, and once it has finally been approved, you go effective. This means you can now lawfully use the prospectus to sell securities under 5.
a. The underwriter pushes the securities for you in one of two ways: 1) Best Efforts : they only purchase from the issuer if they have a buyer on the other side. 2) Firm Commitment : here, the day the registration statement becomes effective the underwriter buys the whole issue, and it is up to them to sell it at a profit. b. Note that the registration statement must include language that the SEC has not approved the securities the SEC has reviewed the prospectus, but they have in no way signed off on the validity of what you say in it.

8.

Gun Jumping [Efforts made to promote the sale of stock, even indirect efforts to condition the market, prior to proper registration are deemed to be tantamount to making offers in violation of 5. Permissible gun jumping guidelines change with each phase of the registration process.]
a.

SEC vs. Loeb, Rhoades (1959): was an old underwriter that touted the company in press releases before it issued stock this was conditioning the market, and the SEC is very sensitive to it.

b. Heres the deal:

1) In Reg - Consistent period: only consistent oral or written remarks, underwriter negotiation (2(a)(3)) or Rule 135 permitted statements. 2) Waiting Period: Only oral statements or oral offers, the only writing can be preliminary prospectus, also underwriter negotiations, or Rule 135 3) Effective: free writing and oral, but everything must accompany prospectus c.

First, you are in registration during the pre-filing period: [is a term of art that refers to a period before youve actually filed a registration statement and
1) Conservative view [Jalils view]: youre in registration when senior management has decided, even informally, to offer securities.

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2) Liberal View (dangerous): youre not in registration until you have an actual deal (or letter of intent) with your underwriters.

When you are in registration, you are in the quiet or consistent (Jalil prefers calling is consistent) period [the quiet period is more aptly called the consistent period before youve filed your reg statement, you cannot condition the market (broadly construed) in ways you havent before. Note 135 provides safe harbor for things you can say.] This means you cannot do anything to promote the stock or condition the market which you havent done before.
1) General Company remarks must be Consistent : you can make general statements about the company, so long as they are consistent with what youve done in the past. If you give press conferences, you can, but if the board never has spoken to the press, dont start now, even just talking about the company. a) Note SEC Release No. 5180 : public companies have a good reason to make announcements in the manner that they always disseminate information, but privately held non-public companies have no real reason to do so unless theyre in the news for some other reason.

2) As to the offer itself , you can do anything permitted by the safe harbors permitted under Rule 135 : Under this rule, the SEC tells you what you can say during the quiet period: You must include a statement that the information youve issued is not an offer, that an offer can only be made by prospectus, and it may say no more than: b) The name of the issuer c) The Title, amount and basic terms of the securities to be offered d) The amount of offering to be made by selling security holders e) The timing of the offering f) Whether the offering is directed to a particular class of purchasers g) A brief statement of the manner and purpose of offering, but YOU MAY NOT NAME THE UNDERWRITERS (it gives you certain credibility). c.

Then you actually file the registration statement with the SEC. Once this is done, you enter the waiting period. During the waiting period:
1) you may make written offers only through circulation of your preliminary prospectus (a red herring). [The SEC comments on the preliminary prospectus, and it gets widely circulated during the waiting period. The final prospectus results - Whoever purchases from you needs to be sent a final prospectus. Note that private plaintiffs can only sue on final prospectus under 11. ] 2) Both the issuer and underwriter can tout the company, BUT THEY CAN ONLY DO SO ORALLY . So nothing outside the prospectus can go out in writing.

3) Of course, all of this is still subject to the antifraud provisions of the acts.

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All of this is seen as gathering indications of interest from the marketplace. You can gather indications of interest, but you cannot take money from anyone or accept any offers. d.

Then you go effective in the post-effective period. Under the SECs position, the final prospectus must look exactly as the last one that you sent out to everyone during the waiting period, except for pricing information (that way there is no surprise). If it is different, you must take time to re-circulate it.
1) During this time, the issuer and underwriter can send information to whomever they want in any medium , so long as they include or precede the statement with (or such communication is preceded by) a copy of the prospectus with anything they send. This is in accordance with the doctrine of free writing.

2) You can also now solicit and accept offers and take money as well.
9.

An issue of timing : The SEC has 20 days by law to declare you effective, but they need much longer than that to do everything they need to do. So everyone always agrees to voluntarily waive the 20 day period, and in return the SEC: a. works to get you effective ASAP b. gives you a choice as to the day and hour you go effective. This is huge, since everyone needs to know this in advance.

10. Shelf Filings : normally, when you file a registration statement, you need to have a good faith intention to go effective ASAP. One major exception is available only to mature companies, who can file a shelf registration and keep their information current with the SEC, and go effective whenever they want to issue securities. 11. Rule 419 Blank Check Companies: some companies raise money with no particular purpose for that money in mind. Under Rule 419, the money must be kept in escrow until the purpose is disclosed to the investors and they approve of it.

12. Examples: a. In Pre-filing Period: 1) Company places ad with Business Week touting the company, when they had always previously advertised the company in BYTE. This would be gun jumping since it is inconsistent. 2) Companys VP begins talking with I-Bank about the offering. This is fine under the 2(a)(3) exception, permitted discussions with underwriters. 3) Companys VP sends the agreement with underwriters to NY office. Thats fine, its just communications within the company, regardless of whether its done interstate. 4) Company solicits more underwriters. Thats fine too, since 2(a)(3) permits discussions with and among underwriters. 5) Company is notified by some of the solicited underwriters that they will not participate, but Company tells them they will get commissions anyway if they move their stock. This would be an illegal offer. 6) Carl hears of the offering and writes in offering to purchase. The offer is not legal, and they certainly cant accept it.

14

7) Companys I-Bank issues a statement disclosing that Company will do an offer, what its for, and how big it is. That would all be ok under Rule 135, but they cant identify the underwriter in the pre-filing period. 8) Company sends out its annual report, as usual. But it is glossier than usual. This is problematic. 9) Companys VP gives a speech that she was invited to give prior to their decision to make an offering. There is no requirement that she is quiet, just consistent, and she can announce the offering.

b. Now in the waiting period: 1) Company issues a press release announcing filing of the registration statement, the offering, and the purpose thereof. It also identifies their underwriter, and gives a statement of earnings per share. This is no good, since any offers in this period must be by way of the prospectus, or orally. 2) A broker at one of the underwriters calls someone and tells her on the phone that she purchase shares, and sends her a preliminary prospectus. Thats fine. It is deemed a solicitation of an indication of interest. 3) Broker now mails a form to someone with a note saying this is a good buy. This is no good during the waiting period the only writing can be the prospectus. 4) A check is sent to the broker. This is no good, you can only solicit indications of interest during the waiting period. 5) A third party underwriter not involved in the offering places info on their website about the offering. They can say whatever they want, since they are not involved. 6) Company puts a hyperlink on their website to the report mentioned in the previous example: this is no good. 7) One of the underwriters sends a letter to its customers describing other stock of Company and how its good stuff. This is fine, since it is technically unrelated. But it cant be a rouse to talk about the common stock they are offering. 8) Broker mails a prospectus to everyone she knows. This is fine, as are her follow-up phone calls. c. Now were effective: 1) Sally is mailed a prospectus by the underwriter, but she never receives it. Instead, she puts in for 100 shares. Black letter law is that you need only to act in good faith, and they have otherwise complied with the law.

MATERIALITY
I.

Materiality : [Is a core concept to most securities laws, helping to ensure efficient and effective disclosure without burying the investor in minutia. Under TSC, a fact is material if there is a substantial likelihood that a reasonable investor would consider it important (useful rule of thumb is 5% test). For uncertain future events, the events materiality turns on both the magnitude of the event and the probability the event will occur [Basic]]. Even though certain things arent asked for in the registration forms, it may still be material and therefore you must include it. Likewise, if something in the registration statement is inaccurate, a plaintiff cannot sue on it under the securities regulations unless it was material.

15

1.

TSC Industries: Under TSC, A fact is material if a reasonable investor would consider it important in deciding how to invest. a. The test is not the investor who is bringing suit, but rather a reasonable investor. b. 5% rule of thumb: If assets are affected by 5%. The Doctrine of Buried Materiality: [disclosure requirements are not satisfied by mere wholesale disclosure; rather, an absense of discretion as to materiality would be counter to the intent of disclosure requirements. Therefore, buried disclosure is no disclosure at all.] You cant err on the side of inclusion, since that will bombard the investor with too much information. Buried disclosure is no disclosure at all. Prospective Information: Basic v. Levinson Things which may occur in the future need to be disclosed on the basis of the probability / magnitude test : a. You balance the probability that something will happen with the magnitude of the event if it occurs.
b. Suppose youre drafting a prospectus and you play golf with the head of another company who casually mentions that you guys should merge. The magnitude out of 100 is 100, since it is the most important thing that can even happen to your company. But the probability is more like 2. Other things can occur which increase the probability, and at some point you need to disclose it (letter of intent definitely needs to be disclosed). c. In the case of a merger we look to board resolutions, lawyers being hired, I-bankers, what has been discussed, whether things stand in the way of the merger, secret exchanges of info, and other indicia.

2.

3.

d. While shareholders might prefer you dont disclose this info, you still have to. 4.

BUT investor notice [Weiglos] certain things, no matter how material are so obvious to investors that they need not be disclosed. Those things which are completely public knowledge need not be disclosed. But who wants to take the chance. This came up in the case, because material misstatements were made, but sophisticated investors who followed the company closely knew they couldnt be true. Social Issues and Disclosure : Of course, certain things may not meet the 5% test but still be material Schlitz: Schlitz was making payoffs to sell its beer. As far as the company was concerned, these payoffs were a good thing for the company, since they were selling more beer as a result. And giving up the companys criminal acts cant be good for share value. But a reasonable investor would want to know if his company is engaging in illegal activity. The SEC agrees. b. Similarly, investors would want to know if you are selling goods in a country with bad politics. c. Exception: Under the Foreign Corrupt Practices Act, any and all payoffs internationally must be disclosed to investors.
a.

5.

6.

The Materiality Rule of Thumb : Any event or fact which could affect earnings or assets by 5% is likely material.

16

7. In the end, the final decision as to disclosure is up to the client, not the lawyers.
8. Note that changes in the stock price after the statement is corrected or revealed may give us insight into the materiality of the misstatement or omission. 9. Examples: a. A misrepresentation is made to a particular investor. The question is whether or not that misrepresentation would be material to a reasonable investor, not that particular investor. If, for instance, the investor in question has specific concerns that are not shared by other investors, then even if he finds something of the utmost importance, its not material. b. Company has several plants, one of which encumbers a piece of land that is not property of the company. The 10-K is to be filed soon discussing the plants they have, and the period for adverse possession on the encumbrance is a few weeks away. However, should the encumbrance be discovered before that, the plant would have to be removed. The best answer here is to put off the filing of the 10K until after the adverse possession period runs that way you wait and once the land is yours theres no issue at all. If thats not an option, despite board members who dont want to disclose this, you should URGE disclosure.

EXEMPTED TRANSACTIONS
1.

A brief listing :
a. Things i. ii. iii. iv. v. vi. b. Things i. ii. iii. c. Things i. ii. iii. an issuer can use: 3a11 [Rule 147] 4(2) [Rule 506] Rule 504 Rule 505 Reg A (only if non-public company) 3(a)(9) a control person can use: Rule 144 (only if public company) 4(1) Reg A (only if non-public company) a reporting company can use: Rule 505 4(2) [Rule 506] 3a11 a private company can use: 4(2) [Rule 506] Rules 504 Rule 505 Reg A 3a11

d. Things i. ii. iii. iv. v.

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e. Investment companies can use: i. 4(2) [Rule 506] 2.

Integration [doctrine that prevents issuers from subverting securities laws and accomplishing piecemeal what they are otherwise prevented from doing in whole without registration. The SEC provides guidance with 5 (really 4) factors that tell us whether 2 distinct offerings are to be treated as one and the same, but certain exemptions contain a safe harbor such that offerings done 6 months apart are safe from integration. Such integration can taint offerings and blow exemptions, tripping up sensitive exemption requirements or triggering gun jumping rules.]: its always running a check on things. Integration considers two offerings, though done at different (or the same) times, to be of one and the same offering. This does not mean they are treated as if they were done simultaneously, but it does treat them as if they were the same offering which means that the properties of one become the properties of the other. a. Integration prevents an issuer from improperly avoiding registration by artificially dividing a single offering [so that] exemptions appear to apply to he individual parts where none would be available to the whole. Whether to integrate calls for an analysis of the specific facts and circumstances [SEC Rule 155 Release] b. Consider two examples: 1) Company A does a registered offering and then a few months later does a Reg D (505) for the same exact stock and all. The Reg D is blown because the general solicitation you did (and perhaps the number of unaccredited investors you offered to) has blown the condition for the Reg D. But the registered offering is ok (no gun jumping problem since the Reg D was done after the registered offering. 2) Company B does a Reg D (505) and then a few months later does a registered offering. The Reg D is still blown because of the advertising and the unaccredited investors, but now the registered offering has a gun jumping problem theyve consummated offers before they were effective.
c.

Five factors to determine if the offering you are doing will be deemed integrated by the SEC: 1) Are they part of a single plan of financing (what is the money being raised for? 2) Do they offerings involve issuance from the same class of securities 3) Whether the offerings have been made at or about the same time:
a) Timing: As a rule of thumb, anything 6 months or closer will be integrated. 6 months to 1 year is arguable, and over 1 year is generally safe. Timing is not dispositive, but its very important.

4) Is it for the same type of consideration to be received? a) Here you can argue about the intent of the investors (like long term debt investments vs. equity) 5) Whether the offerings are made for the same general purposes?

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d.

BUT There are safe harbors for certain offering exemptions regarding integration. (Typically 6 months)

2.

2(a)(3) Underwriter Negotiations Permitted - One major exception to the definition of offer permits an agreement between the underwriter and the issuer (or between underwriters) so that they may reach agreement before registration without violating the securities laws. 4(1) Exemptions:
a.

3.

[The provision carves the massive exemption for secondary trading, while giving teeth to the statutory underwriter provisions of 2(a)(11). It states that 5 applies only to issuers, underwriters, and dealers.] The provisions of 5 shall not apply to anyone other than an issuer, underwriter, or dealer. So technically, it doesnt apply to any secondary trading. But it still applies to secondary offerings.

b.

4.

The Intrastate Exemption : 3(a)(11) [by drafting error, 3(a)(11) is listed as an exempt security, but its a transaction exemption that applies to offerings by issuers who are incorporated and do business in a state and offer securities solely to investors in that state. The safe harbor is rule 147 which includes the triple 80% test, but the exemption is strictly construed (SEC doesnt like it). Securities must stay in state after offering for 9 months, and then are freely tradeable] the 33 Act registration provisions do not apply to any security which is part of an issue, offered and sold to persons resident within a single state or territory (commonwealths etc.), and the issuer does business within such territory. You cant even offer to someone outside the territory (but you can advertise outside if you say its limited to people in a certain state).
a. If you can qualify for the exemption, you dont have to disclose (but you better not make affirmative misrepresentations), you can advertise , you can use unregistered underwriters , etc. Purchasers, after 9 months can resell the stock (not the case for other exemptions).

b. The Intrastate exemption is a political compromise, mainly because states rights lobbies didnt want the federal government regulation issues within a state.
c.

The SEC hates the exemption, and they interpret it strictly. If securities end up in the hands of one person out of state before permitted, the exemption is blown. Integration will not be tolerated people would offer what amounted to the same security in different states but do it under different names so as to utilize the exemption. Where you try to do this, the SEC will consider the offering integrated. We use the five factor test. Five factors to determine if the offering you are doing will be deemed integrated by the SEC: Rule 147 (p. 79 supp) 1) Are they part of a single plan of financing (what is the money being raised for)? 2) Do they offerings involve issuance from the same class of securities? 3) Timing: As a rule of thumb, anything 6 months or closer will be integrated. 6 months to 1 year is arguable, and over 1 year is generally safe. Timing is not dispositive, but its very important. 4) Is it for the same type of consideration to be received? Here you can argue about the intent of the investors (like long term debt investments vs. equity) 5) Are the offerings made for the same general purpose?

d.

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Example: Suppose you offer common stock in NY in Sept. under 3a11. Then you also do a registered offering of notes the same day in all 50 states. The common stock is used to purchase equipment, and the note offering is to hire more salesman. To argue that the two offerings should not be integrated (thus denying the benefit of 3a11 as to the common stock offering). They dont involve the same security or class thereof, but they are offered at the same time. They receive the same type of consideration, but arguably some are making equity investments while others debt. They are not used for the same purpose. e.

Intrastate Exemption Safe Harbor Rule 147 : The rule provides a safe harbor (you can still get by without it, but its a fight). 1) You need to be resident (incorporated) in a particular state. 2) Your principal place of business must also be in that particular state. 3) You must do business there under the Triple 80% test: a) 80% of your assets must be there b) 80% of its revenue must be there c) 80% of the use of proceeds from the offering must be within state
4) You must offer only to the residents of that state, based on domicile (or principal residence?) . But you can advertise out of state, so long as you say on the ad that its limited to people in a certain state.

5) The Securities must be held by for a certain period of time: a) Resales? Offerees must hold onto the offered security within state for at least 9 months. The only way to really ensure that is to escrow the stock for 9 months. b) But they can always resell the security to another resident of the state, without blowing the exemption. The 9 months clock is tacked when investors sell intrastate. c) Purchasers who change their residence must do so in good faith.
5) You must avoid integration of disparate offerings or other intrastate offerings (every part of an issue must comply with the intrastate offering requirements): You can rely on the 5 prong test above for integration, or simply the safe harbor of rule 147 whereby anything over 6 months away will not be integrated. 5.

Private Placement Exemption - 4-2: [Provides the private placement (non public offering) exemption for which 506 is the safe harbor. The guidelines for a valid 4(2) are set up by Ralston Purina. Defining the public as anyone who needs the protections of the securities laws, the court said investors in 4(2)s need (1) financial sophistication and (2) access to information OR affirmative disclosure]. 4(2) is limited to issuers, and the securities are restricted] The provisions of 5 (registration requirements) do not apply to transactions by any issuer not involving a public offering. Private placements are fast and cost effective. Basically, (1) the investors must be sophisticated and (2) they must have access (access or you disclose it) to information allowing them to make a decision. a. General Info on 4(2) placements. 1) There is no monetary cap (but likely there is some amount) 2) Note that under Ralston you cant even OFFER a security to the general public you cannot therefore advertise (but argue that you are trying to boost the company or produce patrons, not investors since youre getting investors privately)

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3) All offers must be made in conformance with the exemption any single non-complying offer will bust the exemption. 4) Issuer must take precautions against resale but the absence of such procedures wont ruin the exemption provided no one resales. 5) Must meet requirements of Ralston Purina as far as sophistication and access. 6) The securities you get are restricted (which means if you improperly resell, the exemption is blown) b.

Ralston Purina: Huge corporation wanted to sell securities without registering them, so they offered the securities to employees. By definition this was not public,
1) Sophistication : [Under Ralston Purina, this is knowledge and experience in financial and business and matters necessary to evaluate investments on their own. Money alone doesnt make you sophisticated (compare accredited investors under Reg D). But the Supreme Court disagreed: anytime you sell securities to anyone who needs the benefit of the securities act (unsophisticated investors), it will be deemed a sale to the public . The public is not the masses, it is anyone unsophisticated. a) Defining sophistication (financially) is hard: education is part of it, but not determinative. Sophistication can also be industry specific. b) A numerical limit has nothing to do with private placements. c) Being an insider does not mean you are sophisticated 2) Access or Disclosure : Likewise, these sophisticated investors need to have access to the information necessary to make a valid investment decision (contrast with 3a11 whereby you need make no such disclosure). Two ways to get investors information: a) Disclose it to them b) Provide them with access : Under 5th circuit definitions, access means you EITHER (1) need to be an insider or (2) have some connection whereby you can get information, but not merely that they will answer questions if you want info (Doran v. Petroleum Management Corp. 5th Cir. 1977). c) Example: Suppose you are a secretary at a major company that has access to all their corporate records: you may have access but youre still not sophisticated.

6.

Regulation D : Private Placements (506) and the 3(b) Safe Harbors (504 and 505) [two 3(b) exemptions and the 4(2) safe harbor these are three inexpensive and efficient ways to raise capital]: Regulation D contains three subrules, 504, 505 and 506. 506 is the safe harbor for Ralston Purina private placements. 504 and 505 have nothing to do with 4(2); rather, they derive from 3(b), which permits the SEC to carve out exempted transactions under $5 million. Reg D is part of the small business initiatives.
a. Authorization: 3(b) of the 33 act permits the SEC commissioner to promulgate rules regarding exempt transactions (though it says securities typo), but no exempting rules may apply to transactions over $5 million. 1) The SEC wants companies to be able to raise capital without the securities regulations being unduly burdensome. This is particularly true with small businesses: Small business initiatives deal mainly with emerging (not just small) businesses. So everything starts out as a small business at some point.

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2) The SEC is very lenient when it comes to Reg D (in part because of the SBIs). b.

3b Offering Aggregation [aggregation enforces the $ caps on the 3(b) exemptions (504, 505 and Reg A) when doing a 504 the other 3bs offered in the last 12 months may not exceed $1 million, 505 the same amount not exceed $5 million. Reg As only count previous Reg As in their $5 million cap.] Beware that the dollar amounts in the 504 and 505 rules are subject to aggregation. That is, in calculating the dollar amounts set up by the SEC ($1 million for 504s and $5 million for 505s) we aggregate:
1) All dollar amounts from any 3(b) offering in the last 12 months (504, 505 and Reg A) 2) Blown 5 violations that youve done in the last 12 months 3) Notice we do not include in the aggregation any 4(2) offerings. 4) Examples: a) Suppose we do $1 million today under 504. This means when we do a 505 within 12 months, we only can do up to $4 million. b) If we do a $4 million 505 today, we can only do another $1 million 505 within 12 months. c) If we do a $4 million 505 today, we CANNOT do a 504 within 12 months, since weve already capped the $1 million under that with the 505 we did. 5) Note that aggregation occurs regardless of integration they are different things. Of course, if you integrate the two offerings, youre still screwed.

c.

Formed for the Purpose Of Doctrine [prevents issuers from subverting caps on investors through the use of organizational form mainly for Rules 505, 506 (limit of 35 unaccredited investors) and 3(c)(1) (limit of 100 investors) an organization is formed for the purpose of when it was formed in questionable proximity to the offering, and more than 40% of the orgs assets go into the investment]: You cannot form corporations and partnerships for the purpose of being counted as one party in the 35 purchasers limitation Typically, corporations and partnerships will be treated as one purchaser BUT If you form an entity for the purpose of purchasing securities, we look through the entity to its members and count each and every one of them. 1) If the entity was formed before the offering was known, then were cool 2) If its questionable, we check to make sure that a maximum of 40% of the assets of the entity are invested in the offering. This way we ensure they werent formed for the purposes of getting in on the investment.

d. Note that all of Reg D is limited to Issuers (not control persons etc.) e. 501 Definitions:
1) The Accredited Investor : [501 of Reg D sets up specific categories that parallel the sophistication requirement of R.P, except that it raises the problem of the moron millionaire (money alone can make you accredited, but that wouldnt cut it for R.P.] The reg refers many times to accredited investors. This is basically the sophistication requirement of Ralston Purina, the Reg tells us how to make judgments as to sophistication, by giving classes of people who will cut it, including: a) institutional investors: banks, insurance companies, investment funds, certain pension funds, trust or partnership with $5 million

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b) 501(c)(3)s c) Any director, executive officer, general partner of the issuer d) Partnerships, Corporations, Trusts: so long as they have at least $5 million in assets. However, the employees are not necessarily protected. e) Any individual who: - Has a net worth that exceeds $1 million or - Makes more than $200,000 individually or $300,000 combined with spouse Note this is a weird exception : under Ralston Purina, being rich doesnt cut it as a matter of law. But under the exemption, its enough to meet sophistication. Likewise, because 506 doesnt require disclosure to accredited investors, they are treated as if they have access, when there is nothing in there to indicate so.
2) Purchaser Representative : Under Rule 506, unsophisticated investors are permitted to use a purchaser representative to meet sophistication requirements: a person who is not connected with the issuer (unless he or she is a relative of the investor) and has such knowledge and experience in financial and business matters to be capable in evaluating the merits and risks of investment. 3) Pre-qualified Investors: If you cant advertise under the reg (except circumstances), how can you find accredit investors. Pre-qualified investors are those you know from before, that you are permitted to approach. f.

502(a): Integration Safe Habor : Reg D presents particular problems because it too is subject to integration. But if you integrate a Reg D offering with a 3(a)(11) that involved tremendous advertising, youve now corrupted the Reg D offering since it cannot involve advertising.
1) Any offering done 6 months before or after will not be integrated as a matter of law (6 months from end of first and beginning of second). All within 6 months will not necessarily be integrated either, but they will be subject to the 5 prongs of the integration test.

g.

502: The Menu of Requirements the other rules refer back and tell us which of these possible requirements need be met for each specific exemption.
1) The Requirements are 502: a) Beware of Integration b) Disclosure Requirements: - No disclosure is required for accredited investors - If the issuer is NOT a public company (Reporting company) the issuer must basically give the investor the same nonfinancial it would have given if it had filed a Registration Statement . The financial info required gets more detailed for offerings of different amounts (under $2,000,000 smallest, $2.5 to $7.5 million is another bracket, and then above $7.5 million). - If the issuer is a reporting company, it must give the investor copies of reports it has given to the SEC, and the opportunity for 505 and 506 investors to ask questions and get answers. - Issuer must give investors the opportunity to ask questions and receive answers

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c) No advertising or general solicitation of any kind - General solicitation defined: you cant send to anyone you dont have a pre-existing relationship with at all - Watch out even if you limit to 35 unaccrediteds in 505 and 506, you still may have approached them the wrong way and violated the general solicitation. d) The securities that you receive though these offerings will not be freely tradeable (they are restricted securities)
h.

503: requires a one page thing to be filed with the SEC within 15 days after the first sale, that will remain private but simply informs the SEC of what youre doing (notice filing). 504 (A 3(b) Safe Harbor) [is a 3(b) exemption, contained in Reg D available to only non-public non investment co. non-blank check co. issuers (no secondary). The rule is leniently construed by SEC, and no quality or quantity restrictions on investors are imposed. There are also no disclosure requirements. However, issuers may only raise up to $1 million (subject to aggregation). There is no gen. Solicitation permitted, and the securities are restricted (unless you use state law exception).
1) Can be done to anyone (no accredited investor requirement or cap)

i.

2) The offering is limited to $1 million (subject to aggregation)

3) You must be an issuer (no secondary offerings).

4) You cannot be a reporting company under 34 Act, or a blank check company.

5) You likewise cannot be an investment company (mutual fund)

6) And a) b) c) d)

you must abide by the requirements under: 502(a): Integration 502(c): No general solicitation 502(d): Restricted Securities BUT EXCEPTION : You CAN advertise and the securities WILL NOT be restricted, IF: - (disclose) The transactions are registered under a state blue sky law requiring public filing and delivery of a disclosure document before sale (if the state youre in doesnt require disclosure, use another state and then use the disclosure document in the state that doesnt require it). OR - (use accrediteds only) The securities are issued under a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (Reg D). No disclosure requirement: Notice that 504 skips 502(b) as a requirement, which is the disclosure requirements. If you do a 504 offering, you need not make disclosures.

e)

j.

505 (A 3(b) Safe Harbor): [A 3(b) exemption in Reg D that permits offerings by issuers only, up to $5 million (subject to aggregation). You may sell to no more than 35 nonaccredited investors (subject to formed for purpose of) and unlimited accredited, but disclosure required for non-accredited, gen. Solic. not permitted, securities restricted)

24

1) The Offering is limited to $5 million (subject to aggregation).

2) You must be an issuer (no secondary offerings) 3) You cannot be an investment company (mutual fund), and you cant have been disqualified under Reg A. a) But you can be a reporting company (unlike Rule 504). 4) There cant sell to more than 35 unaccredited investors a) But you can offer to an unlimited amount of accredited investors the question becomes when youve violated the general solicitation prohibition. b) You can offer to an unlimited number of relatives

5) You must abide by the requirements under: a) 502(a): Integration b) 502(b): Disclosure - EXCEPTION : You need not disclose anything to accredited investors c) 502(c): No general solicitation d) 502(d): Restricted Securities
k.

506 (The 4(2) Safe Harbor) [the 4(2) safe harbor permits only issuers to do offerings to 35 unaccredited (subject to formed for purpose of, but they must be sophisticated or have purchaser rep as well [RP], and must get disclosure) and unlimited accrediteds, no dollar limit, open to invest cos, : Obviously, even if you cant get into the 506 safe harbor, you can still do a 4(2), but the SEC may go after you.
1) There is no $ limit: Because it doesnt derive from 3(b), its not limited to the $5 million cap.

2) You must be an issuer.

3) You cant sell to more than 35 investors (excluding accredited investors). However, note that you can offer to more unaccredited than that 35 but the question becomes when you then violate the general solicitation issue. a) BUT even as to non-accredit investors: must have a financial sophistication to appreciate the risks and make decisions (the sophistication prong for Ralston Purina) . But you dont need access. b) BUT unsophisticated investors can get sophistication by using a purchaser representative a person who is not connected with the issuer (unless they happen to be a relative of the investor), and has such knowledge and experience in business and financial matters to be capable in evaluating the merits and risks of the investment. This makes them sophisticated. So unsophisticated investors MUST use purchaser reps if they wanna be included in the 506.

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4) You must abide by the requirements under: a) 502(a): Integration b) 502(b): Disclosure - EXCEPTION : You need not disclose anything to accredited investors c) 502(c): No general solicitation d) 502(d): Restricted Securities
l.

Rule 507: Disqualification of bad boys who fail to file a form D with the SEC they may not use any of the Reg D exemptions.

m. Rule 508 : Be sure to note that insignificant deviations from a term of Reg D is not fatal so always argue that it might be minor enough to be caught by 508.

n. Examples: 1) A VP of a large company wants to be included in a private offering. Is she accredited? Not necessarily. Title alone wont do it. 2) The assets that we include in the determination of $1 million have to be set and true: we cant rely on speculative things like art. 3) Lawyer is not by law a sophisticated investor. You need to know much more.
7.

Problems with Integration in Abandonment of Different Types of Exempted Offerings - The problem of integration frequently complicates abandoned offerings. If you had a registered deal and you had been taking indications of interest, but then decide to tone it down to a private offering, youre blocked from getting into the exemption by the advertising you did. Likewise, if you go private to public, you had accepted offers in the private which will violate gun jumping rules.
a.

Rule 155 [Because conditions in the securitires markets may shift quickly the rule provides a safe harbor from integration and gun jumping, allowing a legitimate switch from registered to private offerings, or vice versa (in good faith, must abandon, must wait 30 days, and must make certain disclosures)] Abandoned Offering Safe Harbor (Registered Private 4(2) or 506, or vice versa): Because conditions in the securities markets may shift quickly, companies may need to switch from private to public and vice versa. This is part of the small business initiatives as well. The safe harbor ONLY APPLIES to when you go from a private offering under 506 or 4(2) to a registered, or from a registered to 4(2) or 506. 1) If you abandon one offering in good faith (by abandon it means you SOLD NO SECURITIES IN THE FIRST OFFERING and cease all activities under it) 2) Wait 30 days: a) If go private to public [Rule 155(b)], need not wait 30 days before you file registration statement, if the only people to whom you had offered were accredited (if not, then must wait 30 days) 3) If go public to private [Rule 155(c), the reg statement need be included in the private offering a) Obviously, the SEC is concerned that issuers use this integration safe harbor merely as a mechanism to avoid the private offering prohibition on general solicitation and advertising. 4) You can offer the same security using some other mode of exemption (or you can do a registered one) without the troubling aspects of one corrupting the other.

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8.

Regulation A: Mini-Registration [is an underused 3(b) exemption that permits non-public companies to conduct exempted offerings under $5 million (or control people thereof up to $1.5 million). The Reg requires mini-registration, but imposes no requirements on the quality or quantity of investors (i.e. sophistication or numerical caps). Reg A securities are freely tradeable, and the Reg grants generous but limited protections from gun jumping (switch to reg), integration, and 3(b) aggregation.] (A 3B Exemption): you file a mini-registration statement with your local SEC and they approve it (or comment) and then you sell. Reg A is often overlooked since a knee jerk reaction is to go to Reg D.
a.

Reg A offerings are limited to non-public companies (you cannot be a reporting company under the34 Act). No investment companies. 1) Note that this means that control people who use Reg A must be from non-public companies.

b. Reg A offerings are limited, because of 3b, to $5 million in any 12 months period ($1.5 million for insiders).
c.

Reg A , unlike 504 and 505, is NOT limited to just issuers .

d. You cant do a Reg A if youre disqualified as bad boy (SEC dont like you) e. There is no sophistication requirement. f.
Reg A does have certain requirements: 1) You must file a form with the SEC, and until you do so you can only make limited advertising and limited written offers. 2) Preliminary or final offering circular must be furnished to prospective purchasers 48 hours before sales are confirmed, all dealer made sales done 90 days after filing of SEC statement must include offering circular. g.

Reg A permits you to gun jump so long as you do not make offers or sales, you can solicit indications of interest. This is because you need to be able to test the waters to see if its worth your while. This arose out of the small business initiatives.
1) You can switch to registered offering without trouble: If you plan to do a Reg A and then switch to a registered offering (because indications of interest show that you will be able to sell more than $5 million), youve already gun jumped! But Reg A permits you to file your Reg A in good faith and then switch to a registered offering without violating the fun jumping rules: they disregard what you did. 2) You cant quickly switch to a Reg D offering: there you must wait the 6 months safe harbor required to avoid the offerings being integrated.

h. You can freely and do limited solicitation, and the Securities sold under a Reg A are freely tradeable. i. Reg A offerings have WEIRD integration exceptions:
1) They will NOT be integrated with any prior deal. This is so as to encourage capital formation, and there is less concern since youre still required to file disclosure documents anyway.

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2) Reg A offerings will NOT be integrated with any subsequent REGISTERED deal, or any subsequent private deal done at least 6 months later. j.

Reg A only gets aggregated with other Reg A offerings. Even though Reg A offerings derive their authority from 3(b) authority, they do not get aggregated with the other 3(b) offerings (504 and 505). 1) BUT Reg A offerings count against another 3(b) offering: if you do a $5 million 505 and then the next month a Reg A, youre ok. But if you do the Reg A first, it will be aggregated for purposes of determining the allowable amount for the 505.

9.

Regulation S : [To protect U.S. capital markets and their investors from flowback of unregistered securities from abroad, Reg S more or less articulates the breadth of SEC jurisdiction internationally. The SEC divides the world into 3 categories of issuers (based on the likelihood that securities will flow back to U.S.), and establishes safe harboresque guidelines for each (building on the core requirement that their offerings be offshore and use no U.S. directed selling efforts] SEC Jurisdiction over Offshore Offerings : The general goal of Reg S is to protect U.S. capital markets and their investors. a. U.S. person is defined as: any U.S. citizen living in the U.S. that is physically there, or anyone with a green card who is living here in the U.S. b. An offering is not subject to jurisdiction of the United States SEC if it occurs ouside the U.S.:
1) it is an offshore transaction: if buy order comes from outside U.S. or if trade done on trading floor of foreign exchange. 2) there are no directed selling efforts in the U.S. (or offers specifically targeted to a group of U.S. citizens residing abroad): Directed selling efforts are activities undertaken for the purpose of conditioning the market in the U.S. for these securities. They are activities reasonably expected to have the effect of conditioning the market in the U.S..

a) For instance, if more than 20% of a magazine or newspaper in which you advertise circulates in the U.S., then youve made directed selling efforts. b) BUT tours of U.S. facilities are not directed selling efforts. c. A Reg S offerings will not be integrated with any domestic offering.
d.

The SEC divided the world into 3 categories of Issuers: the categories are based on the likelihood that the securities will flow back to the United States.
1) CATEGORY I: offerings of foreign issuers that really have no U.S. connection there is no substantial market interest for their securities (defined mathematically). Also, Non-U.S. or U.S. issuers that offer securities in only one jurisdiction (where you fully comply with those laws) fall into Category I. a) If you are Category I, it must be an offshore transaction and there must be no directed selling efforts in the U.S. 2) CATEGORY II:

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a) Offerings of equity securities (stock) by both U.S. and foreign issuers who are subject to the 34 Act reporting requirements b) Offerings of debt securities by any foreign issuers that do not report under the 34 Act. c) If you are Category II, it must be an offshore transaction and there must be no directed selling efforts in the U.S.
d) Because of your heightened U.S. presence, you must also take steps to make sure that your securities dont wander back into the U.S. Your Reg S securities cannot be sold to a U.S. person for 40 days after the offering. The offerees must agree to it when they first buy into the offering. 3) CATEGORY III: Is everyone else this includes offerings by U.S. issuers who do not report under the 34 Act, equity securities of non-reporting foreign issuers (that have substantial U.S. market interest)

a) If you are Category III, it must be an offshore transaction and there must be no directed selling efforts in the U.S., AND b) If you are offering debt, your securities cannot be sold to a U.S. person for 40 days after the offering c) If you are offering equity, you cannot have your securities sold to a U.S. person for 1 year.
e.

Special Case of the Internet : SEC Release in 1998

1) For Non U.S. issuers offering on the Internet, you need to put disclaimers on your pages stating that they are not being offered in the U.S. a) Of course, this is a recommendation (they cant make Non-U.S. issuers do anything really), but they will come after you if you violate 5. 2) For U.S. companies they are stricter: you must take reasonable precautions like password protections before you can see the offering info on the internet. 3) But if you take precautions and act in good faith, and a U.S. person still sneaks in, the SEC will let you slide.

SECONDARY DISTRIBUTIONS
1.

Secondary Distribution : [Secondary distributions are done by someone other than the issuer, (generally, statutory underwriters and affiliates under 2(a)(11), but whom still must be concerned with 5 they must register, or seek exemption under 144, 4(1), or Reg A. Such distributions should also be distinguished from secondary trading which occurs only after these securities have come to rest in the public.] 2(a)(11) Statutory Underwriter : [Under 2(a)11) this is any person who purchases securities with a view to distribution to the public. The definition serves to prevent unregistered securities from reaching the public in exempted transactions through a middleman. To sell these restricted securities, the SU must either register or utilize some exemption himself. The problem is that these secondary offerors have to concern themselves with securities laws: 4 says that 5 doesnt apply to

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anyone other than an issuer or underwriter if they become classified as an underwriter, then they lose their automatic 4(1) exemption from registration. You can become an underwriter in one of the following ways: a. b. c. d. e. by purchasing from the issuer with a view towards distribution by offering and selling for an issuer in connection with a distribution by participating in the distribution or underwriting effort by selling securities of the issuer on behalf of a control person by purchasing securities of the issuer from a control person with a view towards distribution

Control persons and holders of restricted securities may not sell their securities into the public markets without registration of their offering, or some exemption (but for different reasons).
2.

Holders of Restricted Securities (mainly holders of 504, 505, 06, 4(2) or 4(1 ) securities): any person (entity) who has purchased restricted securities from an issuer, with a view to distribution [TO THE PUBLIC] (anyone who needs the protection of the securities Act under Ralston Purina) in the near future will be deemed an underwriter and therefore cannot offer to the public without registration or some exemption. Likewise they screw the issuer who gave them the restricted securities in the first place .
a.

Rationale: we are concerned with regulating offerings of securities to the public. Where a person purchases securities in a Reg D exempted offering, they are not the public. Therefore, when the turn around and sell their securities to the public, they must register their securities, or find some exemption (like 144). With a view to distribution : [this test is a component of classification as a statutory underwriter; using the rear view mirror test, it determines intent to distribute from subsequent actions. Holding for 1 year or less creates presumption of intent, 2 years or more is safe, and 1-2 is argued either way. Presumptions of intent can be rebutted by showing of profound circumstance.] We are concerned with state of mind but in reality, we judge state of mind by what you ended up doing. This is the very reason that the securities you get in an exempted transaction are so frequently restricted if you were able to turn around and sell them you would become an underwriter and you would need to register that sale.
1) The SEC seeks to characterize as underwriters those who act as links in a chain of transactions through which securities move from an issuer to the public. [Rule 144 Preliminary Note] 2) But there is a safe harbor: If you hold the securities you purchase for 2 years, you are golden and youre not seen as having purchased it with a view to distribution. 3) EXCEPTION : if you purchase the securities and unforeseen circumstances arise, then you may be able to convince the SEC that you had the requisite intent when you bought it. But this has to be really profound circumstances (you cant just say the market went down). 4) Of course, you should always argue they didnt have a view to distribution.

b.

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5) Note that escaping the with a view to test isnt enough its in the disjunctive you can still be an underwriter even if you escape the test. The only safety is in the safe harbor. 3.

Control Persons or Affiliate (Insider) : Under 2(a)(11), issuers also include control persons Control persons will be deemed one in the same as the issuer, and therefore cannot sell to the public without registration or some exemption. They are therefore dubbed underwriters (as are anyone that purchases securities from them with an eye to distribution to the public) by the securities regulations.
a.

Control Person: [As a prophylactic measure, control persons are deemed one and the same as the issuer, and therefore must register or seek an exemption to offer their securities. 2(a)(11) provides a definition based on control that would include control shareholders and directors, but the more accurate test would be anyone within a group of people who can compel the issuer to register.] The accepted definition is that an affiliate is a person who directly or indirectly controls, is controlled by, or is under common control with the issuer. Directors are definitely control people, as is executive management (up to a point). Significant controlling shareholders (it is a question of fact and depends on there being no other large controlling shareholders that comprise the rest of shareholders for instance, if you try to exercise control but get voted down, you dont count) are also control persons.

b. Always start out by arguing first they are not control people.
c. The classic definition was anyone who has the power to compel the issuer to register their offering, but this is wrong its anyone who is within a group of people that have that power.

d. When discussing control persons, remember (and argue) that there are protections in place under 10(b)(5) that really achieve the goals of the SEC with regard to control persons in a sense then, control person registration requirements are really somewhat prophylactic. e. Of course, argue they are not control persons. f. 4.

Wolfson: we didnt have time because were busy executives is not a valid defense.

Rule 144 : [Provides a safe harbor for secondary offerings by control persons and statutory underwriters under 2(a)(11). Generally, control persons must sell under volume limitations in regular broker transactions, and ensure that their company is current in public filings (so not available to non-public company affiliates). Restricted sec. holders may sell in regular broker transactions, under volume limitations after 1 year holding period, provided company current in filings, or wait 2 years to sell without any restrictions.] The Secondary Offering Safe Harbor (Persons Deemed Not to Be Engaged in a Distribution and therefore Not Underwriters) Rule 144 provides a safe harbor for (1) when control people can sell stock without registration, and (2) how and when holders of restricted securities may sell without registration.
a.

A seller shall be deemed NOT to be engaged in a distribution of securities (which means they arent underwriters) (144(b)) if :
1) 144(c): The issuing company MUST be a reporting company that files reports under the 34 Act and the company must be current in their filings .

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a) Obviously then, the safe harbor is not available to private companies and it means that control persons of non-public companies need to use 4(1 ) b) This is why when companies offer stock options and other stock packages to their insiders, they often have to agree by contract to keep current on their filings (otherwise the securities they offer to employees are useless since they cant be sold without registration).
2) 144(d): Holding Period: a) Holders of restricted securities must hold them for at least one year. b) Control persons dont have to worry about holding periods (unless they buy restricted securities) 3) 144(e): Volume limitations : We want to prevent dumping of the stock all at one time. a) In one 3 month period, you cannot sell more than the greater of: - 1% of that class of securities that is outstanding - the average of the weekly trading volume of that security during the four weeks preceding the sale. b) Note that person is defined in a way by 144 such that units like husband and wifes sales of shares will be aggregated. 4) 144(f): Sold in regular way brokers transactions they must be sold into the anonymous market through a routine broker transaction. Rule 144 is not available for private sales, and the seller cannot condition the market or pick who he sells it to. 5) 144(h): If more than 500 shares of stock (or securities worth more than $10,000) are sold in any 3 month period, a form 144 must be filed with the SEC notice filing. 6) 144(k): 2 year home free rule: a)

For restricted securities holders, two years ends everything two years after the purchase of a restricted security, you may sell those securities without regard to any other limitation in 144. This means 2 years after the company can be late in their filings, no limitations on volume, need not use brokers.

b) For control persons, the provisions of 144 never fall away (the 2 years means nothing). They are not ever free from being control persons. b.

Summary : 1) Restricted Securities holders must: a) Hold their stock for at least one year at which point, if the company is up to date on its SEC filings, - they can sell under volume limitations - provided they do so in regular way broker transactions - provided they do a notice filing (if necessary) c) After 2 years all restrictions fall away

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2) Control persons can (these requirements never go away): [might be better to compel the company to register the offering of their stock on their behalf] a) Sell their stock at any time, provided the company is up to day on their SEC filings (note this means control person of small company would have to use 4(1) - subject to volume limitations - provided they do so in regular way broker transactions - provided they do a notice filing (if necessary) 4) Control persons who hold restricted securities must: a) Hold their stock for at least one year, at which point, if the company is up to data on its SEC filings, - they can sell under volume limitations - provided they do so in regular way broker transactions - provided they do a notice filing (if necessary) b) After one year, they can sell whenever they want, subject to all the restrictions in 2). 5.

The 4(1) Exemption [another choice for Insiders] [Because 4(2) is limited to issuers, 4(1 ) is read into securities laws to permit private placements by insiders (144 prohibits privately negotiated transactions). Accordingly, the exemption follows the requirements of Ralston Purina. The securities are restricted.: Technically, the 4(2) exemption is available only to issuers and not control persons. The SEC therefore drafted 4 - Insiders can do private offerings by abiding by the guidelines of Ralston Purina. a. While 144 prohibits privately negotiated transactions, this is exactly that 4 is for. b. Note the securities you offer are restricted. c. Technically, a 4(1 ) is also available to holders of restricted securities (a restricted security holder could possibly offer it to another accredited investor in a 4(1), but apparently there is a risk in doing so because you risk putting yourself into a string of people who could eventually become underwriters (if the investor you give the security to ends up being caught as an underwriter, youre going to be liable as well). Rule 144a Institutional Investors [Exempts large institutions from registration when selling large blocks of restricted securities to other large institutions. The main requirement is that the securities in question are not publicly traded] : Large investors want to be able to sell restricted securities in a more organized way but without incurring registration requirements as an underwriter: they normally cannot use 144. So the SEC adopted 144a, which says if you buy large blocks and youre an institution, you can trade among yourselves and you will not be deemed an underwriter.
a. BUT the securities must not be traded to qualify for the exemption. This would normally be a problem, but such institutions so often receive tailor made securities that are not traded by open markets.

6.

7. Examples: a. Jess purchases stock in a 3a11 intrastate offering which he then wishes to resell. This does not implicate Rule 144 in any way. b. Z issued 2 million shares pursuant to a 505 exemption. However, there were 47 nonaccredited purchases in that offering (which would blow the exemption). Susan now wishes to sell her shares. She can use rule 144 the SEC is lenient in the interpretation and there is no requirement that you have securities from a valid Reg D, just a Reg D.

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Bill, a control person of O company is looking to sell his control block to A. All discussions have been on a direct and personal basis so far. This would be improper he cant use 144 to do it since it has to be a regular brokered transaction, instead, this would be a 4. d. Bill instead hires a broker to sell his shares. This is an ok 144. e. A company has been late in their filings. C has restricted A shares and wants to resell them. She has held them for 14 months. She cant do it until 2 years, because they are late in their filings. c.

FOR VALUE
1.

For Value [To be caught by the acts, sales of securities must for value under 2(a)(3) def of sale. To be for value, either party to transaction must receive some tangible benefit, or the recipient must be presented with some investment decision. However, certain for value situations are exempted from being for value (i.e. stock dividends), while others not for value are regulated by alternate means (i.e. corporate spinoffs).] The concept of For Value is one that is key to securities laws 5 deals with offers and sales, which MUST BE FOR VALUE. If it is not a sale (under 2(a)(3) for value, its not a sale by definition and therefore not subject to the 5 registration requirements. a. For instance, if Bill Gates gives 100,000 shares of Microsoft to his son as a gift, it does not require registration.

2. Defining For Value:

a.

Tests - you must satisfy either test 1) Either party to the transaction, both giver and receiver, cannot receive any sort of tangible benefit (the joy of gift giving is not a tangible benefit). 2) There can be no investment decision (decision between two forms of economic benefit) on the part of the recipient BUT just because there is no investment decision doesnt guarantee that it is not for value. Stock giveaways are for value: Companies (dot-coms) were giving their stock away, which creates markets in their stock they were going public overnight without any registration or IPO. The SEC deemed it illegal, even though under the for value concept it was perfectly ok. 1) To get around the concept, the SEC said that the companies that were giving away stock were getting instant markets in return, which was a tangible benefit. Stock Dividends (even with choice) not for value: Companies will often pay out more stock as a dividend on existing stock if that is a disposition or sale for value, it requires registration. But the SEC has held this is not a sale for value. 1) Technically, where stockholders are given a choice between stock and cash as a dividend this is an investment decision and it is for value. But the SEC has taken an anomalous position whereby this is deemed NOT for value. 2) This is particularly odd since DRIPS (dividend reinvestment plans) are considered for value. Convertible Stock : Convertible stock involves a sale of two securities, since the ability to convert into another form of stock is for value. 1) When you register a convertible stock, you must register the initial issuance as well as the security into which it is convertible (but if it is convertible after time, you probably cant and dont need to do it right away).

b.

c.

d.

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e.

Changing the terms of debt or equity: If you change the terms, you must register it as a new offer it is an offer for value. 1) BUT if the changes are immaterial mechanical changes (like changes in the timing of payments without changing maturity), you need not register. The standard is materiality: whether a reasonable investor would consider the change to be a material change in the security. Changing the state of incorporation: the SEC has taken a position that changing the state of incorporation doesnt change anything. Corporate Spinoffs are NOT for value (but regulated under the 34 act): Company X often has a business Y which it wants to spinoff as a separate subsidiary, and pass that stock off to the shareholders. To do this the company drops the business into a wholly owned subsidiary, holding the stock as a corporation. Then it distributes the stock to its own shareholders.
1) The SEC is driven crazy by this: like the dot-com giveaways, it creates a market in the stock of the subsidiary without registration. 2) Instead, they say that brokers cannot trade the security (with a provision under the 34 act). In this way they accomplish a 33 act regulation through the 34 act.

f.

g.

h.

Exchange Offerings : Technically, exchanges of one security for another would be for value. But there is 3(a)(9) a transaction exemption for exchange offers [provides an exemption whereby issuers may offer securities to their own shareholders in exchange for existing shares, provided such offering is done exclusively with existing shareholders, with no consideration other than exchanged shares, and involving no other securities.] 1) If an issuer offers to exchange one security for another with its own securities holders , and follows the following rules, it will be exempt. The exchange must be done exclusively - Exclusivity does triple duty: a) it must be done exclusively with existing shareholders, b) exclusively with the exchanged securities c) exclusively with no other consideration (Where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange)
3) Status of 3a9 securities : The status of securities you get when you exchange are the SAME as the securities you give up. 4) Integration : is a problem here. If you have a debt security out there and you are doing a 506 offering of common stock. If you use 3(a)(9) to offer the debenture holders the stock that you are offering in 506, it will be integrated, and we blow the 3(a)(9) because now youre not offering exclusively anymore. And now youve probably blown the 506 as well, since you likely exceeded the number of accredited investors or engaged in general solicitation. 5) Examples: a) Company offers tax advice to help its existing security holders who take other securities instead. This violates 3a9 since it is extra remuneration. b) Extra money given: no good. c) Company wants to do an exchange offer as well as a registered offering. If the security they are offering to the new investors is the same as that they are offering in the 3a9, it wil be integrated and you will blow the 3a9 exemption.

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3.

Mergers and For Value Problems : Rule 145 [4 things: (1) codifies SEC reversal of position such that exchange of stock mergers are now deemed for value and must be registered [145(a)] (2) provides a safe harbor for gun jumping regarding statements necessary to disclose material information to merger party shareholders [145(b)] (3) imposes resale restrictions on target company and its affiliates now deemed underwriters under 145(c) (4) carves safe harbor for resales by such parties [145(d)] The position of the SEC had, for a long time, been that mergers (whereby shareholders of Company A receive new shares of Company B in exchange for their stock) was not an offer for value. With the adoption of rule 145, however, they had a change of heart. (its not protected under 3(a)(9) because youre not offering securities to your own shareholders.

READ UP ON THIS

a. Under rule 145, classic exchange of stock mergers must be registered because they are for value.
1) 145(a) : sets out transactions subject to the rule those where a vote of security holders is taken [required] regarding: a) a reclassification of securities, but not a stock split or change in par value b) a merger where new securities are exchanged for old securities c) certain kinds of asset transfers involving the issuance of new securities 2) Gun Jumping Safe Harbor: But under that interpretation, we have a big problem with gun jumping: many of the information leading up to the merger announcement (and the announcement itself) is material information that needs to be disclosed. The solution is 145(b): The information that can be disclosed (similar to 135): a) the issuer can state its name b) the names of other parties to the transaction c) a brief description of the businesses, d) the date, the time and place of the meeting to vote on the transaction e) a brief description of the proposed transaction f) any statements required by law 3) The Underwriter Merger Problem ? 145(c) says all parties, except the issuer, to a 145 transaction are underwriters, as are all affiliates (control persons) thereof. a)

Parties defined: the entities involved in the transaction (but not the issuer), and the their affiliates. No shareholders are parties except insiders and control persons. This basically means that the target company and their affiliates are the underwriters for purposes of rule 145(c).

b) Defining the former control people as underwriters is relevant because they may no longer be control people after the merger but we want to prevent them from freely offering the securities. c)

Example : in a standard merger where A issues stock and gives it to B shareholders in exchange for their B stock, A is the issuer. B is clearly a party to the transaction and is an underwriter of A stock that it receives. The affiliates of B are also underwriters. However, this has nothing to do with the shareholders or affiliates of A. But the actual shareholders of B are not a party to the transaction, so they can freely resell.

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d) Perhaps the best solution is to simply register the affiliates resales when you register the exchange itself. If its been registered, then none of this matters at all. 4) Affiliates Resale Safe Harbor: Affiliates caught by the rule can use either 144(d)(1), 144(d)(2) or 144(d)(3) to resell their securities: but it may make more sense just to register the re-sales when you register the merger. 1) 145(d)(1) : Company B or affiliates of B whether or not now newly employed as affiliates of A may resell the issued company A stock they received, provided they follow 144(c) [current public info as to issuing company], 144(e) [volume limitations], and 144(f) [brokers transactions]. Were maintaining their control person status whether or not theyre not control people of the new company we treat them as if they were. 2) 145(d)(2) : Company B affiliates who are not affiliates of Company A at the time of the sale in question, can resell without registration if (note no volume or broker limitations): - They hold the stock for at least 1 year - Company A has public information available. 3) 145(d)(3) : Company B affiliates who have not been Affiliates of Company A for at least 3 months (3 months cleansing period) may resell stock provided: (1) they hold the stock for 2 years. 4) Note that affiliates of B who become affiliates of A through the merger and are at the time of sale affiliates of A, must use 145(d)(1), in particularly because they are control people of the stock they are trying to sell. 5) Note that affiliates of B who become affiliates of A but then leave can use 145(d)(2) as soon as they can satisfy the requirements thereof (for instance, that its been 1 year from the merger). 6) Note that affiliates of B who become affiliates of A but then leave must wait 3 months after they leave until they can rely on 145(d)(3) [because the company isnt current on public filings], and its been at least 2 years since the merger. This sucks for them, especially if they dont quit until after the two years (they will have to wait 3 months).

EXEMPTED SECURITIES
1. 3 Exempts various types of securities from registration altogether Exempted Securities: [these securities would otherwise meet the Howey test, but have been wholly exempted from registration, for example government bonds] But they are still subject to the anti-fraud and other provisions exempted securities are only exempt from registration. a. 3(a)(2): Any security issued by the U.S. or any state thereof (municipal bonds). This was necessary to prevent government entities from regulation one another.

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1) The determination as to what exactly is exempt is left to the IRS if it is exempt for tax purposes, it is exempt from registration. So the IRS has stringent requirements as to what is exempt, and the SEC goes by those. 2) BUT the SEC still is able to regulate these securities under the 34 Act brokers cannot underwrite or sell a municipal bond offering exceeding $1 million without some form of disclosure statement. b. 3(a)(3): Commercial Paper - Any note, draft, bill of exchange which arises out of current transactions or the proceeds of which are to be used for current transactions, that has a maturity not exceeding 9 months. c. 3(a)(4): Securities issued for religious, educational, benevolent, fraternal, charitable, or reformatory purposes and not for profit.

d. 3(a)(5): Any security issued by a savings and loan association, building and loan association, cooperative bank, or similar. e. 3(a)(6): Any interest in a railroad equipment trust (they were a strong lobby when the 33 Act passed). f. 3(a)(7): Certificates issued by a receiver, trustee or debtor in bankruptcy case.

g. 3(a)(8): Insurance or endowment policy, annuity contract, or optional annuity contract issued by a corporation. h. 3(a)(10): Any security issued by court order i. j. 3(a)(12): equity issued in connection with the acquisition of a holding company of a bank under Bank Holding company Act. 3(a)(13): A security issued by or any interest in any church plan, or companies excluded under Investment Company Act.

SECURITIES LIABILITY
1. A word on common law fraud (why the 33 Act rocks): Before the 33 Act you had to rely on common law fraud claim (argue it as backup for exam), and you needed to show: a. Misstatement: something had to simply be said incorrectly b. Reliance: the buyer had to show he relied on the fraud c. Privity of contract: there needed to be some privity between the tortfeasor and the aggrieved party d. Causation: you had to show the misstatement or fraud was the cause of your loss e. Scienter: you couldnt commit common law fraud unintentionally. This left people with very limited recourse the average person would never show these things. In turn, this left no disincentive to be commit fraud, and surely no incentive to be careful (in fact, the less careful you were the more if showed you lacked intent to deceive).

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2.

11 Registration Statement Liability : 11 only applies to registration statements themselves. It does not apply to Reg. D, 3a11, 3a9, 4(2) those all require something else as a basis for suit.
a.

You cannot sue on a preliminary prospectus: this is why the SEC was always so concerned about making sure you have a prospectus out there in final form (so there is something to sue on).

b. Requirements:
1) It must contain an untrue statement of material fact under TSC (that a reasonable investor would consider it important) OR it must omit a material fact that makes the statement misleading. a) BUT Standing - You must not know of the untruth or omission at the time you purchase securities we dont want people buying lawsuits. 2) Privity not really needed (contrast 12): The purchaser must simply be able to trace his shares back to the IPO through a chain of other securities holders. You need to show that the stock youre holding and suing on is the same stock that came from the registration statement in question. (Probabilities wont cut it cant proportion liability based on proportions of stock out there). But sometimes tracing can be a bitch, and prevent recovery. 3) What a) b) c)

you dont need (vs. common law) Reliance you dont even need to show that you read it. Scienter: you can sue even if it was a mistake Causation: you need not show that the loss was caused by the misstatement.

c.

Liability under 11 is Joint and Several : except more recent amendments say that directors can sue one another for contribution, and outside directors may be given proportional liability under 11(f)(2)(a).

d. Who may be sued under 11:

1) You can sue any person who signs the registration statement. This will typically include the issuer themselves (company), the CEO, CFO, CAO, and all the directors (whether they call themselves advisory board or whatever, whether they are about to become directors or already are, or even have resigned [dont want you to put big names on reg statement without liability to them] who can all be sued personally, whether they actually sign or not). a) It is against SEC policy for the issuer to indemnify anyone who is personally liable (Globus)

2) Underwriters are liable as well: they get the same liability as the issuer which serves its purpose underwriters are as a result very careful about what they do. a) Instead, they just take large commissions to cover the risk b) They are only liable up to the amount they underwrite, and a specific limit within a syndicate

39

3) Experts can be liable: Experts are liable for the section they provide an opinion on (they dont actually sign the prospectus, but the SEC makes them agree to potential liability). a) Standard: the expert needs to do the thorough job that would be the standard for a prudent expert in that field. If they are a recognized expert, they act in good faith (believe they were right) and do what they are supposed to, there is no liability.

b) Likewise, people who are liable for the statement (except issuer, who is always liable) cant be liable for the experts statements, provided they didnt know it was a wrong statement and they used a reasonable expert in his field. c) Lawyers may get squeezed into this liability, but only if they expertise something.

BUT Defenses :
e. 11(b)(3) Due Diligence Defense : No person (other than the issuer, who will always be liable if something is wrong) shall be liable for statements or omissions (so this covers the CEOs, directors, underwriters etc.) provided they can provide that: 1) After reasonable investigation (so you build a big file together for each person involved to show diligence 2) They had grounds to believe, and did believe, that the statement made was not untrue. 3) Cant use due diligence defense if you left disclosure up to the lawyers like in Kern. 4) You can rely on experts, so long as they are reasonable experts. 5) Standard : those claiming due diligence defense will be held to the standard of a reasonably prudent man in the management of his own property (except for experts different standard). a) BUT each person is held to a slightly different standard. Those with certain responsibilities will be subjected to a higher standard in that area of responsibilities (sales vs. finance). Outside directors without expertise probably less stringent standard than outside one with expertise, and less than CEO and CFO. (1) The varying standard doesnt excuse anyone, but it may make a difference when its a close call. (2) BarChris: Bowling alley goes belly up because of bad financials. Russo was CEO and on executive committee and knew everything that went on, and he made all the arrangements highest standard for due diligence defense. - Kirsher was the CFO and a CPA it was impossible that with a tiny bit of digging he wouldnt have found out. - Director was in similar boat. - Lawyers should have known certain contracts not legally binding, need to know obligations under statute, but is not liable when didnt know about

40

financial transactions (was entitled to rely on financial statements prepared by accountants) Outside director not liable for expertised portions (entitled to rely on experts, but cannot claim he thought they covered everything when a little bit of digging would show otherwise)

(3) Example: plastics company has two directors and they are preparing prospectus one is college chem. Prof and the other is a travel agent. Both will have to ask questions and investigate, but more is expected of the prof. he has to visit the plant and ask questions to the experts that the travel agent didnt know about. 6) Rule 176: Not a safe harbor, but lists relevant circumstances in determining when the conduct of a person is reasonable (not exhaustive). f. 11(b)(1) Person Withdrew and informed SEC : Note that under 11(b)(1)(b) directors who resign must also inform the SEC why they have resigned in order to escape liability under 11. 11(e) Damages : 1) The amount of damages under 11 is the difference between the amount paid for the security (AT THE OFFERING PRICE) and the value of the stock at the time the suit is brought. a) If the price of the stock went up despite the discovery of the misstatement, no damages. b) Damages can never exceed the offering price. If IPO for $10, and you buy in at $90, then it drops to $8, you can sue for $2. If it went to $11, then no damages. 2) New amendments permit the defendant to argue for a limitation on damages where the stock price went down for reasons other than the securities violation. 3) Note that provided you can show reliance and scienter (which may be hard), you might wanna try to use 10(b)(5) because it will allow for greater recovery (not limited to what falls below offering price). h. i. 3.

g.

Statute of Limitations : is very short - 11 must be brought within 1 year of discovery of the cause of action, in no case more than 3 years.
14 - You cant waive compliance with any provisions

12 Liability:
a.

12 Direct Privity is required: Only direct purchasers may sue (and only those who show that the stock they bought was attached to the violation) 1) Example: suppose you sell stock to 1000 people, and in 500 instances you forget to send prospectus. Youre ok for the other 500 (though the 500 that didnt get prospectuses can sue you under 12(a)(1). 2) Minority view: you can set up a chain of privity

41

b.

Statute of Limitations : is very short - 12 must be brought within 1 year of discovery of the cause of action, in no case more than 3 years. 12(a)(1) : any person who offers or sells a security in violation of 5 this covers blown exemptions, failures to register, gun jumping, failure to deliver prospectus, etc. This basically just gives teeth to the requirements of 5.
1) Remedy: purchaser gets his money back plus interest (thats it). 2) Note there is no scienter, no causation, and no due diligence defense. 12(a)(1) is a strict liability provision. But to have standing, you need to have been one of the people for whom 5 was violated.

c.

d.

12(a)(2) : any person who offers or sells a security by means of a prospectus or oral statements relating to it that contains a material misstatement (or material omission). This basically sets up liability for the prospectus or oral statements that accompany it, made by anyone selling the stock. 1) Remedy: purchaser gets his money back plus interest (thats it). 2) But 12(a)(2) has a due diligence defense (that IS available to issuers as well [compare 11 due diligence defense not available to issuers]). If an issuer has used a bad prospectus but has done reasonable investigation in preparing it, then youre ok. 3) 12(b): 12(a)(2) indirectly requires a showing of causation if the stock went down for some reason other than the misstatement, the violator is ok. 4) There is no reliance requirement.

e.

Limiting 12(a)(2) - Gustafson: Sale of stock in private transaction. Defense tried to assert that a Reg D offering (where disclosure documents are required but it is not a genuine full blown prospectus) is not covered by 12(a)(2) liability because not by means of prospectus. The court actually bought it. 1) By a strict reading of Gustafson, 12(a)(2) is limited in its reach to registered offerings by issuers and their control persons. 2) The case seems to say that only registered offerings would be covered, since the word prospectus in the Act is being strictly construed so as to mean a prospectus for a registered offering. Likewise, oral communications must relate to that prospectus. This means that 12(a)(2) may or may not cover 504, 3a11, or Reg. As of a public nature., but it would surely exclude something like Reg D offerings. This is ridiculous, since they cut 12(a)(2) down to do exactly what 11 already does. 3) The case confuses IPO, primary offering, and a bunch of other terminology. The dissent is actually correct (Thomas) when he points out that the majority is reading the word prospectus in the statute too narrowly. But everyone is wrong since they say that only public offerings require disclosure (when in reality almost all private placements also require some form of disclosure) Ginsburg knows the deal- she says, what about private offerings boys?
a) By that reading, if you had a fraudulent disclosure under Rule 506, there is no remedy, and that makes no sense (be sure to include this on exam).

42

b) Likewise, it means it doesnt cover secondary trading. 4. 17: The SEC Liability Section: 17 casts a very broad coverage for the SEC to impose liability on issuers and other parties but there is no private right of action under 17 it is limited to the SEC only. It is the means by which the SEC brings actions under the 33 act. a.

It is very broad : It shall be unlawful (you can end up in jail, fined, injunctions etc.), to make any untrue statement (broad, doesnt say where you have to make it), to engage in any fraud (broad, they can attach liability to any fraud, impropriety, shadiness etc.) Even where there are no damages under a private right of action (price didnt go below offering price), there is SEC liability and they will bring action against you. The defenses of 11 and 12 are not there, but there is some language regarding scienter in 17 which may provide a similar type defense for the defendants.

b.

c.

5.

Control Person Liability : Once you find liability for the issuer or other person, you can attach control person liability. 15 of the 33 Act every person who controls a person who is liable under 11 or 12, shall also be jointly and severally liable with that person. They need not do anything wrong at all, they are just liable. 20 of the 34 act covers.
a.

Rationale : control people ought to have some responsibility for people they control. It also prevents senior management from being able to set up a fall guy. Control person liability is necessary to catch the people who would otherwise slip through the cracks (for instance, majority controlling shareholders or officers who didnt have to sign the registration statement).

b. Note there is no state of mind requirement for control person liability you simply need derivative liability, and then the control person is liable (except defense).
c.

Exception : good faith defense - if the control person has no knowledge, and didnt have reasonable grounds to believe (knew or should have known standard), there is no liability.
1) Basically, you cant stick your head in the ground if you control a company, you need to control it (but you only need to be reasonable). 2) To satisfy the burden you need to have checks and balances in place, you need to do what you can to make sure these things dont happen.

d.

Backup Liability Respondeat Superior: control people are liable like in any other tort action for the acts of people they control (but thats state law)
1) Advantange: RS is useful where the control person escapes liability of 15 or 20 because of the exception for lack of knowledge or reasonable belief you can still get them on RS.

ENFORCEMENT

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1. The staff at the division of enforcement at the SEC begins by opening a file on you they take their complaints from the public very seriously but at this stage things are very informal. They may call you and ask about clients. a. b. c. At this point you need to ask whether this is a preliminary investigation. The SEC has to tell you if it is. You also need to ask whether your client is a target : but the SEC DOESNT need to answer that one. The SEC has no subpoena power at this power. This is tricky since you should cooperate to the point that it helps your client. Ferrara and Nerkle Overview of an SEC Enforcement Action Counsels preliminary responsibility in the preliminary investigation is to assess tactical considerations for responding to an informal inquiry counsel must balance the corporations interest. There is great incentive to provide the information necessary to allay the staffs suspicions of violation without graduating to a formal investigation. Counsel also may be able to quickly eliminate areas of concern and focus the staffs attention on relevant information. On the other hand, counsel may wish to prevent a wholesale disclosure of broadly identified corporate info, and may be forced to make a more limited presentation of information. The fundamental tension is disclosing enough to get them off you back, or disclose too much that they know theres a problem. Note that the SEC is not very influenced by the use of political muscle to try to head off an action. But it worked in Wheeling Pittsburg Steel.

d.

2.

The staff now goes to the commissioners and they vote on whether to issue formal investigation. If so, they issue a formal order of investigation. Now they have the power of subpoena to get all the info they need (its a big deal). At this point, the target can issue a Wells Submission [Before commission begins their formal investigation, target can submit disclosure of information to head off action the tension is providing enough info to get them off your back, while retaining ammo for defense and without incriminating self] . There is a big problem with these how much information do you give to the Wells Commission (and you obviously cant lie) to head off an action while still retaining ammo for he defense. a. Always have your white collar defense lawyers review your submission but dont have them sign it (it makes it look like youre admitting something is up).

3.

4. Oddly enough, the SEC has no criminal enforcement abilities they defer to the Justice Department for criminal prosecution. They can also use the FBI (also dept. of Justice) for their services. 5. The SEC loves to settle, but they also can get injunctions, fines, censures, suspensions, or cease and desist orders against you. a. Injunctions: are powerful, since they get injunctions saying you wont violate securities laws anymore and if you do, you automatically have committed a criminal offense theyve taken a civil remedy and made it criminal.

THE SECURITIES EXCHANGE ACT OF 1934

1. While the 33 Act was primarily a consumer protection statute (that sought such protection by requiring complete disclosure), the 34 is actually a regulatory statute it tells business and people alike how to conduct their affairs.

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2.

The 34 Act Created the SEC [Unlike the consumer protecting 33 act, the 34 act is a regulatory statute. In addition to creating the SEC, the 34 Act also regulates multiple facets of the securities industry: exchanges, broker dealers, public companies, insiders, tender offers. Likewise, it provides for various anti-fraud provisions]. As a purely historical note, in between 33 and 34 you registered with the FTC.
a. The SEC is a 5 commissioner body appointed by the president and approved by Congress except that not more than 3 of such commissioners can be of the same political party. In practice this means that when one democrat comes off, a republic comes on. This was intended to de-politicize regulation and instill confidence back in the market. b.

The 34 Act also set up and authorized filings under EDGAR .

3. One thing the 34 Act Regulates is Exchanges and the way you trade in one:
a. b. 6 all exchanges must be registered. 5 it shall be illegal for anyone to trade securities in an unregistered exchange.

c.

Margin Trading : Used to be you could purchase stock using the stock itself as collateral for a loan you used in the purchase. 1) 7 sets up a series of rules as to how and when (if at all) you can trade on the margin. This was a response to many of the abuses that led to the 29 crash. Abusive Practices : 9 - It shall be unlawful for any person to use the securities exchange for the purposes of creating a false and misleading appearance of active trading with false prices or false orders. 2) This covered Wash sales, which were now prohibited (trading back and forth between involved parties to drive the price up. 3) Basically, everything must now be a bona fide arms length transaction you cannot manipulate or set price. 4) In theory, this means that the prices in the market are a true reflection of the value of the stock that the whole anonymous market attaches to it.

d.

6.

The 34 Act also regulates Broker / Dealers : a. 11 those acting as brokers cannot trade against the market a broker on an exchange can only take orders for his customers, he cannot trade for his own account. 1) The concern is that the broker is supposed to negotiate for you the best price on the stock purchase or sale if hes in there for himself there is an inherent conflict of interest.
2) Exception: Of course, brokers can trade on their own accounts (big banks do it all the time) so long as they use a third party broker that anyone else would use. 3) 15 to form a broker dealer you must have significant capitalization we dont want them going belly up. 4) The actual day to day regulation of the broker dealers is deferred to the NASD, a self regulatory organization that must report back to the SEC but handles applications for new broker dealers and regulates existing ones.

45

a)

19 regulates SROs and establishes their authority. They need to be licensed by the SEC.

7.

The 34 Act also regulates public companies / reporting companies ( 12) [Companies who are required to register under the 34 act, which subjects them to, inter-alia, periodic filing requirements and 16 insider regulation (as to registered stock). Where an issuer desires his securities be publicly traded, such security must be registered under the 34 act, which brings reporting company status to the issuer (also, any issuer with more than $10 million in assets and 500 equity shares must register as the same)]:
a. The 34 Act requires a type of registration for public companies (totally different from registering offering of securities). In order for a public company to have its stock traded on a registered exchange (or if it is above a certain size), it must register that stock (using form 10, a public document that publicly discloses certain info [and financials] about the company). 1) You only need to register securities if you want them to be publicly traded if its not then no need to register. a)

Exception: if your company has more than $10 million in assets AND more than 500 equity shareholders , you must register your securities with the SEC, whether or not you want the stock publicly traded.
(1) So if you do a Reg D for 501 accredited investors, you still have to register the security under the 34 Act. (2) NOTE: even if you register the offering under the 34 act but then only 2 people buy, you still need to remain a public company for one year (at the end of the year you test to see if you are still a public company) that way those 2 who bought in arent left in the shit.

2) Just registering one security makes you a public reporting company, even if you have multiple classes of stock.
a) If you register a class of stock, then you are subject to the reporting requirements of the 34act. b) BUT where the provisions of the 34 act that are specific to a class of stock are specific to what you register. For instance, if you only register common stock, your preferred stock obviously cannot be publicly traded, but it also means that the 16(a) and (b) provisions do not apply with respect to the preferred. 3) Reason is simple: we dont want securities traded unless people can easily found out about them. Once the company files the form 10, they have put info out there in the public eye about themselves.

b. Once youve registered as a public company, there are other requirements:

1) 13 : you must make periodic filings (10K is yearly and gives audited financials, 10Q simply gives unaudited financials and both give info about the company including how much execs get paid, how much stock execs have, and all relevant

46

facts about company, management decisions etc.). You must also file the 8K updates. 2) The Williams Act . 13 also imposes requirements for public companies under 13(d): a) 13(d): If anyone purchases more than 5% of sock in a public company, they need to file a 13(d) with the SEC disclosing why theyre buying, where they got the money from, if they want to affect control etc. all within 5 days. (1) Exception 13(f): Institutional investors who purchase less than 20% of public company can merely file the 13(d) equivalent at the end of the year as a 13(f). This is because they just buy a lot of stock and it would be a pain in the ass. b) Note [CHECK] that you can still use 144 even if you are required to file a 13(d). 3) Proxy Regulation : 14 strictly regulates solicitation and execution of proxies. If it was not regulated there would be tremendous potential for abuse shady issuers wouldnt give all the info before they took your vote. a) You cannot solicit proxies unless you also mail a 10K. b) You cannot solicit proxies unless you also mail with the solicitation a proxy statement (drafting is regulated by 14 its easier than a prospectus but still a pain). 8.

The 34 Act also regulates Insiders: BUT ONLY IF THE SPECIFIC STOCK IN QUESTION HAS BEEN REGISTERED UNDER THE 34 ACT.
a. 16(a): Filing Requirements : every director, principal executive officer, and 10% shareholder must file a form 3 alerting the SEC of who they are and how much stock they own. 1) every month, if these same people make trades, they must file a form 4. If you trade nothing you file a form 5 re-updating your position at the end of the year. 2) Note that 16(a) is the least enforced provision in the securities regulations. 16(b): Short swing trading every 16(a) person who buys and sells or sells and buys the companys security within a 6 month period and makes a profit must turn that profit over the company. 1) If you buy at 10 and sell at 15 5 months later, you gotta give it up. Sell at 10 and buy at 5 2 months later give it up. 2) Theory: the SEC doesnt want insiders trading their own stock there are rules for insider trading, but this is sort of prophylactic. c. 16 also says it is illegal for 16(a) people to sell their stock short.

b.

9.

10 of the 34 Act: Is perhaps the most sued on section of any federal securities law. a. Under the authority of 10(b), the SEC adopted Rule 10b-5 (note that rules under the 33 act are numbered and those under the 34 Act numbered based on section they come from).

Rule 10b-5: It shall be unlawful for any person, directly or indirectly, to:
(a) employ any device, scheme, or artifice to defraud

47

(b) make any untrue statement of material fact or omit to state a material fact necessary in order to make the statement not misleading under the circumstances (c) engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person.

In connection with the purchase or sale of any security

b.

Who can sue ? 10b-5 permits a private right of action. Anyone who purchases or sells securities in relation to the information can sue. 1) You must be a purchaser or a seller: a) For purchasers, this stratifies the reliance requirement you need to have actually purchased in reliance of the false statement (or relied on the lack thereof in cases of omissions b) For sellers this is more complicated Mere Diminution in value is not enough this is not covered [Blue Chip Stamps] if you want to be able to recover if the stock value goes down, you need to sell, and then sue. (1) But if you purchase a stock and then sell it high when the glossy misstatement is made (before its uncovered) you have no damages to sue for. But the person who buys from you in reliance of those statements has a cause of action.
2) BUT Aborted Seller Doctrine [Because rule 10(b)(5) requires a violation be in connection with the purchase or sale of a security, those injured in connection with a sale may not be able to consummate such sale (because buyer walked away due to misstatement or other fraud). Therefore, the doctrine treats the sale as consummated to enable suit in such instance (which is why 3 defines sale as contract for sale)]: someone who was about to buy but didnt because of the ugly misstatement is treated as if they had bought otherwise, every time someone loses a sale because of a misstatement, the seller wouldnt be able to sue. a) The aborted seller doctrine comes up mainly in the case of mergers if you were about to have a merger where some company was going to purchase all of your shares in a merger, and a material misstatement (negative) is made in the info given to purchaser, and they walk away from the deal because of that misstatement, you have no one to sell to before you can sue. But you can sue under aborted seller doctrine. b) This is why the 34 act defines sale in 3 as any contract for sale. 3) Aborted Purchaser Doctrine: isnt certain to exist, but presumably would cover those who claimed they would have purchased if they had known glossy information that was improperly omitted. 4) But the defendant need not have purchased or sold.

c.

A private plaintiff suit under 10b-5 requires: 1) that the misstatement was material.
2) that the conduct in question was in connection with the sale of a security: a) We first have to find the thing in question is a security. [See above]

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b) Texas Gulf Sulfur: They found mother load of minerals but didnt issue a statement, then issued a misleading statement but they didnt buy or sell securities. Other people did. The only requirement is that the statement touched in connection with the purchase or sale of ANYONEs security the offending party doesnt have to trade. c)

10b-5 is violated when assertions are made in a manner reasonably calculated to influence the investment public [Carter Wallace]. But at some point, it gets too remote [In Re Financial Corp. of America Shareholders Lit].

d) All we need, is that any person, whether connected to the transaction or not, makes a material misstatement.
e) But if we get too broad, we have read the in connection with requirement out of the statute. f) Note that Jalil thinks the villain here is the lawyer he is the one who was giving advice, and should have questioned why the CEO wanted to issue the statements he did.

g) Problems: (1) Company places a series of ads in medical journals for a new drug they developed. The drug later proved unsafe and was withdrawn form market, and the price dropped. Investors brought a 10(b)(5) suit against the company does this satisfy the in connection with? The court here found it was in connection with [Carter Wallace], even though the info was in medical journals and not business magazines it is not a requirement that the information be directed at the public, only that it was reasonably calculated that they can take hold of it and use it. (2) Anderson was retained to give advice for a company as to accounting practice for issue. The advice they gave it turns out was wrong, is this in connection with at some point it gets too remote. [In Re. Financial Corp. of Am. Shareholders Litigation]. 3) 10b-5 requires reliance the plaintiff needs to show that they relied on the misstatement in question when they bought or sold (except in cases of omission where you shouldnt have to prove you relied on silence). a)

BUT Fraud on the Market Theory : is an exception to reliance theory you need not provide individual reliance if you can show that the market price of a security is determined by the available material information [Basic v. Levinson]. Basically, investors who purchase securities in the market do so in reliance on the integrity of the price.

4) 10b-5 requires causation the loss had to be the proximate result of the material misstatement in question. 5) 10b-5 requires scienter : may be inferred

49

a)

Hochfelder: Read into 10b-5 a requirement of scienter. This was huge, since it greatly limited how easily you could sue [contrast with 11 which doesnt require scienter, reliance etc.].

b) Scienter can be inferred from course of conduct, parallel trades etc. c) A grossly reckless disregard of the truth can also satisfy scienter requirement. d) Intentionally putting on blinders satisfies scienter requirement. Note that if the company knows something but keeps one person in the dark to make their statements so that they cant meet scienter requirement its still scienter. e) Example: company officials deny that they have a contract that they do this is scienter: even though youd argue under materiality that it was good for the company to deny, it was false and they made it on purpose knowing it was false. Intent to make a false statement, regardless of the purpose, is scienter. It doesnt have to be scienter to defraud the public or affect stock price.

6) Damages: are limited to actual damages there can be no punative damages. But even actual damages can far exceed the fraud you committed. a) It used to be joint and several liability, but the reform act wrote in proportional liability. d.

Breaches of fiduciary duty not actionable under 10b-5: Sante Fe: case drew the line there is a distinction between state law for fiduciary duty breach and federal securities laws even though the breaches of duty may affect stock price, they are not deceptions within the meaning of 10b-5. It is better addressed by state corporate law. [try to parallel argument]. Statute of Limitations : Congress never adopted a statute of limitations, but the courts read in the same one from the 33 Act one year after discovery and never more than 3 years. Recent reforms to 10b-5 The Private Securities Litigation Reform Act (PSLRA ) : there has been mounting concern over strike suits that result from 10b-5 people were pretty much suing whenever the stock price went down, hoping they would just find some violation in discovery. The reforms have made it harder to sue the plaintiff has to plead specifically what the violation is, who made it etc. Violations Based on Omissions - Affirmative Duties to Disclose: The basic rule is that the mere possession of material information does not require disclosure companies discuss things in private all the time. You dont necessarily have a duty to disclose. At all times other than below, you can say nothing, and if asked you can say no comment [Basic v. Levinson] EXCEPT: 1) When you trade your own stock 2) Once youve already mentioned the topic you must give updated details and discuss how the issue or matter changes. Obviously you need to argue what is broaching the subject, whether its the same subject etc.

e.

f.

g.

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a)

Once youve broached the subject [once youve touched the tar baby], you need to disclose if the situation changes , and

b) Once youve broached the subject [once youve touched the tar baby], you have a duty to correct rumors that are false.

c) BUT there comes a time when you no longer need to update the question is whether the stock price is still based on the original news.
d) Example: you tout a product, but then weeks later find out that it doesnt do what its supposed to you have to disclose the new information. e) Example: suppose a new drug was developed last year and you made many announcements regarding it but a year later you find out it was no good there comes a point when you no longer need to give updates from the original statement. A year probably meets the cut, the question is whether you still believe the stocks price reflects the original news. (1) Note that for some companies, the value of their stock may be based entirely on one statement (like for one product they are based on). 3) If something gets out there accidentally and its wrong , you have a duty to correct the misunderstanding or misstatement, but only if it somehow came from the company (in which case its the same as broaching the subject and having to immediately update). 4) When youve selectively disclosed already, you must disclose to the marketplace [reg FD] - Regulation F(d) : where an issuer has made info available to any analyst (intentionally or inadvertently), the information must be made available to all analysts. Basically the days of the good old boys network are over. This is meant to level the playing field. 5) By contract with the exchange : if there is significant trading volatility the company must issue a statement saying either that it doesnt know why the stock is trading so much (if they really dont), or disclose why the volatility is occurring. a) NYSE has these contracts, but the NASDAQ doesnt. b) This can push issuers into difficult situations: shady traders who hear about a possible merger may trade the stock a lot in order to get you to announce the merger. 10. Insider Trading : Insider trading liability is a cousin of 10(b)(5) it stems from the market manipulation prong of 10(b)(5). Economists think the laws of insider trading are stupid Jalil doesnt agree. The idea is that the average investor really believes the playing field has been leveled once you lose it you take all the integrity from the securities markets.

Be sure to consider that you cant simply sue under 16(b) short swing profits since that might be easier of course, 16 only applies to stocks that are registered under the 34 act, whereas 10(b)(5) applies to ANY STOCK, public or private.

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Approach:
a.

Is it related to a Tender offer ? Rule 14e-3: it is illegal to trade on inside information with respect to a tender offer, regardless of whether or not you have a fiduciary obligation.
1) It is too hard to police tender offers, and they are incredibly important the rule has been upheld by the courts. 2) Had this rule been in place during the time of Chiarella, he would have been put away (or with misappropriation theory had it been in effect then 3) Note that the in possession of defense doesnt apply to 14e-3 (or at least, its never been an issue).

b.

Was the information material ? The information obviously must be material before it triggers insider trading prohibitions. People who work at companies always have more info about a company than outsiders but not all of it is material.
1) Try to argue that because the insiders were trading on it, it is material (but would a reasonable investor consider it important). 2) Try to argue that the information they knew of was simply an opinion or a prediction and therefore less likely to be material, or that if the insiders had disclosed all this info it would overwhelm shareholders too much info (rejected in Basic). 3) It need not have changed their investment decision, it simply needs to have affected the total mix of information [Basic].

c. Was there scienter on the part of the defendant? d. What is your position in relation to the company?
1) Chiarella: The mere possession of material insider information is not a bar to trading . a) Chiarella was a printer who figured out what company was being taken over, traded on the information, and made $30,000. b) The court ruled that absent some fiduciary duty to someone, the mere possession of insider information is not a bar to trading. Chiarella had no fiduciary duty to anyone he was just a printer. 2) Who has the fiduciary obligation: under Chiarella you must be trading the stock of the company in which you are a fiduciary (but Jalili believes that the notion of temporary insiders includes people on both sides of a deal). a)

Fiduciaries : Anyone who receives the insider information in the course of their employment with the issuer has such an obligation: directors, officers, secretaries, clerical help people who have access to the information as fiduciaries of the company. This can potentially run all the way down the line.

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b) Temporary Insiders : People who get the info on a need to know basis so that they can perform services for the issuer - this includes law firms, accounting firms, investment banking firms. c) But try to stretch argument that information didnt come to them as their role as fiduciaries. d) Former employees may be included otherwise everyone could just quit their jobs to trade without liability. 3) Misappropriation Theory [Trading on material non-public info gained in breach of a duty to the source of the info (course of employment, relationship of trust etc.)(OHagan, better ex. Carpenter, codified in 10b-5-2) This filled the gap (trading by those other than fiduciaries or temporary insiders) left by Chiarella. You must trade to be covered by misappropriation (there can be a chain of misappropriation). a)

OHagan: Jalil doesnt like this case because its not really a misappropriation case, but the Supreme Court was looking for one. Lawyers in this case were given info by the company as part of the legal work, which makes them temporary insiders in terms of Chiarella, but the court decided to use misappropriation. Breach of fiduciary duty requirement is satisfied if you misappropriate confidential (non-public) information you gain in some relationship of trust (i.e. employment).
(1) in breach of a duty owed to the source of the information. [OHagan]

b) Better example is Carpenter: Column in wall street journal where they write about stuff heard on the street. Employees took the info and traded on it before it was published. This is textbook misappropriation. (1) Note: If the owner of the journal had traded on the info it would be fine (its still manipulation of the market, but not insider trading). (2) Suppose analyst for G.S. does digging and finds info they cant trade on it either. G.S. can trade on it, since thats the point of having the analysts work for them. But the analyst cant herself trade (but probably can if she gets permission from source of info). c)

SEC Rule 10b-5-2: codifies misappropriation a non-exclusive listing of circumstances for misappropriation. It includes any relationship of trust of confidence, which can be employer, parent, child sibling, spouse, any specific confidentiality agreement breached.
(1) Example: Suppose son tells father info about sons company and father trades on it. Its a relationship included in the rule its misappropriation. Doesnt matter whether you try to talk them out of trading if they trade theyre liable.

d) But if you tell the source that youre going to trade, technically youre not liable under misappropriation.

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e. Why are you buying or selling the stock?

1) Exceptions: Insiders need some way to be able to trade stock hence the distinction between trading on the basis of material insider information vs. merely possessing it [Insider trading liability requires trading on the basis of material non-public info yet insiders are frequently (if not always) in the mere possession of such info]. a)

Adler: If it can be shown you were going to trade anyway, you can do it without violating insider trading prohibitions. One way to do this is to set up a stock sale or purchase plan, so you have a presumption that youre trading for reasons other than the material information.

b) Also try to argue some legitimate purpose in the trading need to raise money etc.
c)

SEC Rule 10b-5-1: codified and limited Adler.

(1) The rule (b) creates a presumption in (b) that youre trading on the basis of unless you can prove otherwise. So you need to show an affirmative defense to prevail. (2) The defenses (c): you have to demonstrate that before you became aware of the info, you (1) entered into some binding contract to trade, (2) you instructed another person to buy or sell securities, (3) adopted a written plan for trading securities.

d) Adler had to sell stock because of a financial predicament, not because of material information. e) Example: law firm finds out information about a company they do work for, and they had just put in an order to sell the stock (the info is damaging) you need to be able to show that you put in the order before you came into the information (or perhaps argue its not material information). f.

How you got the information - Tipper-Tippee Liability: The test depends on whether the tipper has himself breached a fiduciary duty (by receiving a personal benefit) by divulging info.
1) Dirks: was a trader who heard rumors about a company so he investigated by going to the company and interviewing someone. He called all his clients and told them to dump the stock based on the info. a) As a preliminary matter, Dirks presents a problem: the SEC has a tension whereby they want to encourage the flow of information from companies but there are also concerns for tipping and insider trading. b) Dirks didnt trade on his own account so there is no misappropriation theory to be applied here so what kind of liability is there? Dirks was innocent if you got the information from the insider and the insider neither received nor expected any benefit from giving the info (dispassionate conveyance), there is no violation. Had Dirks made promises of benefit to the tipper, hed be liable as a tippee.

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(1) The gain need not be pecuniary: you can expect future business, it could be giving the info to a relative so they can do well for themselves, being pissed off at your boss and wanting to talk to screw the company, you want to be a hero as an analyst thats all enough. c) GET QUOTE FROM DIRKS ON how otherwise it would have inhibiting impact on the market. d) Note that once the chain is tainted from the original tipper (because they expected benefit or if they misappropriate the information), its tainted all the way down the line provided you can prove that each person knows where the information originally came from and that it was a Dirks violation [eventually, it becomes common rumor and people dont know where its from they arent liable]. (1) The chain can be tainted from any point along the chain forward - by either a financial benefit, or any misappropriation, provided the people beyond the point of taint know of it . (2) BUT only those who actually either trade or tip with expectation of benefit will be liable in the chain after the original taint. e)

Dirks is used to get the tipper who doesnt trade because he has not traded, we cant use misappropriation on him. Those who have traded are liable under Dirks, the problem is really those who havent traded. But in any event, once youre caught by Dirks, it contaminates the whole chain.

2) Recall you can also have chains that are tainted by misappropriation (maybe not yet decided by Supreme Court). 3) Schritzer: Overhear you can trade But you cannot intentionally spy Suppose youre on an elevator and you overhear people talking about a merger you can trade on it, so long as you didnt intentionally spy on them . Its a free country (so long as its not covered by 14e-3). If you spy, youre liable for misappropriation (wholly separate liability). a)

Electrician case: electrician is doing work in building and intentionally sets his schedule and positions himself so as to hear more things to trade on. Thats misappropriation.

4) The trip wire for Dirks is very slight [Jalil] if you give an interview and tell them info so that youll get favorable reviews in the future, thats probably enough of an expectation of a benefit. 5) Dirks liability chains can begin with OHagan Misappropriation: suppose you tell someone in confidence information that you merely overheard (you had no duty whatsoever) and then they tell other people. The person you told is now liable under Dirks and OHagan and anyone on the chain after them is also liable (provided it can be shown that they knew it was misappropriated in the first place).

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g.

Damages: you can be sued by both the SEC (and you can go to jail) and any private plaintiff who qualifies under 10b-5, and they can recover the difference between the price they purchased or sold at and the market price after the material information is made known, EXCEPT THAT:
1) SEC Suits: under 21(a) of the 34 act, the SEC can sue you for up to 3 times the money you made (or kept / didnt lose) this is basically treble damages. 2) Private Suits: the damages recovered by the SEC get deducted from any possible recovery by private plaintiffs. a) Example: suppose the SEC gets you for $3 million. You sue and are able to recover $1 million. You can recover nothing. b) Rationale: as a trend, there is a growing prejudice against private securities litigation the idea here is to let the SEC take care of business.

h. Examples: 1) Insider trades on material non-public information. Liability [Chiarella] 2) Insider has law firm, and lawyer trades. Liability [Chiarella] 3) Insider tells A of info in exchange for benefit. Insider is liable as tipper under Dirks. a) If A does nothing, no liability. b) If A tells others, whether for gain or not, hes liable as a tipper under Dirks (if he does it for gain, hes caught, if he tips for no gain, he had already given benefit to get the info) c) If A trades, hes liable under Dirks (obviously he meets the requirement of knowing where it came from and that it was tainted, and he gave the benefit to A). 4) Insider tells A for benefit. A tells B without receiving benefit. B tells C for no benefit, who trades and knows where info came from. a) A is liable (see above). b) B is NOT liable he didnt trade, he didnt give any benefit before he tipped, and he received no benefit as well. c) C is liable, but only because he traded, and only because he knows where the info came from.

ACCESSORY LIABILITY
1.

Primary / Secondary / Aider and Abbetors

a.

Primary Violator [Primary violators are the culprits themselves they re the ones who actually violated the law in question]. This is the culprit himself. Hes the bad guy who violated the law without question. Only primary or secondary violators can be sued by private plaintiffs. Secondary Violator [Someone who knowingly helped the primary violator, but didnt get any of the payoff he acted intentionally with malice aforethought, but did so for his own good purposes. The difficulty is distinguishing secondary from aider and abettor, for which we rely on the brightline and substantial participation tests (easier standard).] the law is gray, but it is someone who knowingly helped the primary violator, but didnt get any payoff. He had malice aforethought and acted intentionally, but was somehow not the person who received any benefit from the transaction. He does it for his own good purposes.

b.

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c.

Aider and Abettor [Someone who facilitates the primary violator, but without necessarily intending a violation (if they intended, theyd be secondary violator). To distinguish from secondary violator, we can use brightline or substantial participation test (easier standard). Note that private plaintiffs cannot sue aiders and abettors: they facilitate, but they do so without necessarily intending to allow a violation. In short, they didnt intend the ramifications of what they did. If they had the intent to cause a violation, theyd be secondary violators.
1) Central Bank of Denver : limited liability for aiders and abettors because there is no private right of action against them.

a) The theory of the holding was that if you were really going to require scienter in 10bs, then you couldnt have liability for those who lacked genuine intent (though recklessness probably still satisfies intent). Its a strict statutory construction. (1) The other theory was reliance this would mean defendants were liable even where plaintiff never relied on the actions of the aider and abettor. (2) The absence of 10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the securities Acts.
2) Of course, the SEC can still sue aiders and abettors. The Supreme Court has reaffirmed this (as has Congress in the PSLRA). a) But try to argue there should be no aider and abettor liability under 10(b)(5) at all: Hochfelder read scienter as a requirement into any 10(b)(5) violation for private litigants, and it later followed that the SEC had to show the same. The requirement of scienter is the basis for Central bank, so under a consistent reading the SEC shouldnt be able to bring aider and abettor liability at all. 2.

How do you distinguish between them [Wright v. E&Y]:

a.

Brightline Test : a defendant must actually make a false or misleading statement to be held liable they must be active in the fraud. They must be an active participant. Substantial Participation Test : is less stringent that brightline standard, and merely requires that someone substantially participated in the fraud which leaves open what that means.
1) Critics of the test say it reads out important distinctions of Central Bank. 2) Under this test, gross negligence or recklessness may satisfy knowing you were aiding.

b.

c.

Example : A announces it intends to acquire B. The announcement includes audited and unaudited financial statements. Bs management had previously falsified its records (but A didnt know). Bs management once again overstates the firms combined earnings in the announcement. A discovers it and discloses it. The price of shares then plummet, and shareholders sue Bs management and As management.

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1) Bs management is obviously the primary violator here. As management however has the questionable liability they are definitely aider and abettors, but may not be secondary. If you apply the substantial participation test they may be liable as secondary violators (and theyve used unaudited financials, so that is perhaps substantial participation) But under the brightline test, they havent actually done anything. 2) If instead Bs management had been convicted of falsifying the records, then we move up a notch they surely pass muster under the substantial participation test, but they may even pass under the brightline test now theyve done something which is pretty much reckless disregard of the truth.

DUTIES OF THE SECURITIES LAWYER

1. Note that when you have these difficulties, the best person to see is the ethics prof at your school. 2.

Kern: company left their disclosure obligations and decisions to the securities lawyer (S&C) it is not the job of the securities lawyer to decide what is disclosed. The leave it to lawyers mentality sucks. a. In this particular case he was also a director, but he made those decisions in his capacity as a lawyer, not as director. These are decisions for the issuer, not the lawyer. b. Kerns defended that he was applying the Basic test this would be fine, except that he took possession of the outcome instead of reporting the outcome and letting the issuer decide, he actually did the test and then decided. Thats wrong. There need be a distance between securities lawyer and the issuer. SEC v. National Student Marketing: there was a merger that had to close by 4PM on a certain day or it wouldnt happen. There was tremendous financial pressure on everyone to get the deal closed, but it couldnt close until a comfort letter was issued by accountants (saying we dont that things arent kosher). But there were problems and they couldnt issue the letter everyone looked to the lawyers to close the deal anyway. The merger went through and everyone was happy, but then the company went under and everyone sued. a. The SEC brought action against the lawyers, who they claimed owed a duty to the general public as securities lawyers. Most settled so we wont know the outcome, but some did fight it to the end and won against the SEC. b. But the court seemed to buy the theory that securities lawyers owe a duty to the investing public (maybe) , they just felt bad for the lawyers here so they let them off.
Problems of attorney client privilege: In Re Carter & Johnson: the client wouldnt make proper disclosure. The SEC took action against the lawyer, because the client wouldnt follow securities laws. They said you had an obligation to make the client follow the rules. a. The case was eventually dismissed on a technicality, so the question remains what do you do? b. First go to the board of directors. If the board refuses to follow your advice as to proper disclosure (in which case they are intentionally evading securities laws), and if they dont listen the only alternative is noisy resignation. c. The SEC holds lawyers to a high standard, and they will visit the sins of the client on the securities attorney.

3.

4.

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INVESTMENT COMPANIES
1. After the crash of 29, Congress was also concerned with investment pools the potential for abuse created by such pooling investment arrangements was rather large both in organization and implementation. Investment pools today are more commonly known as mutual funds , but the term is nowhere in the 40 act.

2.

Investment Company Act of 1940 (40 Act) [intended to target pre-crash abuses of investment pools, the 40 act regulates investment companies. This regulatory statute mandates registration and carves exemptions therefrom, and dictates organizational and operational rules and regulations.] Like the 34 act, the 40 act is a regulatory act (contrast the consumer protection nature of the 33 act). It is an extremely complicated and detailed set of regulations for the investment companies.
a. In order to discuss any of these tests to see if youre an investment company, you need to first decide if the things you hold or trade are even first securities you need to first define the thing in question as a security . 3 Defining an Investment Company [Conceptually, its a company whose primary business is investments in securities. Despite the subjective test (issuer holding himself out as primarily engaged in trading securities), the objective test (issuer engaged in trading securities and investing more than 40% of its assets in securities), the SEC position under rule 3(a)(1) is that youre not an investment company if less than 45% of assets are in securities, and less than 45% of income comes from the same.] Just as the 33 act requires your instrument to be a security before its regulated, the 40 act requires that you meet characterization as an investment company. Conceptualize the test as is the companys business primarily being an investor - their role in these tests needs to be as an investor to meet the tests (they need to be on the investor side of the securities in the tests below). There are three real tests: 1) Subjective test: Any issuer which is or holds itself out as being engaged primarily in the business of investing, re-investing or trading in securities. 2) Objective test: Any issuer which is engaged in the business of investing or reinvesting or trading in securities, and owns or proposes to acquire securities having a value in excess of 40% of its assets if 40% of your assets are in securities, youre an investment company a) Rationale: every company has cash that at some point they put into securities this protects them from being caught by the definition. 3) SEC Rule 3(a)(1) : Notwithstanding the objective test, an issuer is NOT an investment company if: a) less than 45% of its assets are in securities, AND b) less than 45% of its income is from trading of securities 4) 3(b) - Holding Company Exception [youre not an investment company if you can qualify under 3(a)(1) if you are engaged, directly or indirectly, in a business other than investing, through a subsidiary. This basically exempts holding companies from having to register under the 40 Act.]: Youre still not an investment company if

b.

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youre an issuer that is , directly or indirectly through wholly owned subsidiaries, primarily engaged in a business OTHER than investing. a) Basically, if through your subsidiaries youre engaged in a business (by meeting the tests set up above [we look through the parent and check the percentages based on the sub or subs] other than trading securities, youre not an investment companies. b) This exempts holding companies, whose sole operation is to hold securities and would otherwise be caught by the 3(a) definitions. 5) 3(b) SEC Discretionary Exemption: Even if you get caught by any of the above definitions, the SEC can selectively exempt you if you apply to them with what they believe is good reason. 6) Inadvertent Investment Companies: Fifth Avenue Coach Lines bus companies used to be privately owned they sold all their busses and got out of the bus business, but instead of dissolving they held their cash and decided to invest it. The SEC brought action against them more than 40% of their assets were in securities, and now they are an investment company. 7) BUT : Rule 3(a)(2) Transient Investment Company Doctrine [Upon liquidation, companies have a one year grace period from being declared an investment company subject to registration requirement, provided you have a good faith intention to do something with their money other than investing it.] Notwithstanding 3(a), youre NOT an investment company for one year (grace period), so long as you have a good faith intention of doing something with the cash other than investing it in securities. c. 3(c)(1) Investment Club / Exemption [Issuers that have 100 or less owners (subject to formed for purpose of doctrine and 10% test) will not be investment companies and are therefore exempt from 40 Act registration. Initially intended to cover small scale investment clubs, this exemption backfired and led to billion dollar hedge funds.] Notwithstanding the definitions above, if any issuer investment company has less than 100 owners, it is not an investment company. Its a de minimus exemption. 1) This led, most notably, to hedge funds : they typically can get into the billions, but they simply make sure they keep it under 100 investors and avoid registration as investment companies. 2) How do you get securities in the hedge fund to the 100 people in the first place? You use 506 accredited investors, so you can offer the securities in your Hedge fund to as many as you want so long as you dont sell more 100. But for the 40 act exemption itself, we dont care about the character of the investors. 3) BUT The 10% Test : Any entity which owns more than 10% of a (3)(c) (1) gets looked through for purposes of the 100 investors. This is huge. a)

Exception : it is ok for the 10% or more holder, and they will not be looked through, if they themselves are an operating company (like a bank etc.) our concern with the 10% is merely to prevent funds of funds.

b) Of course, an individual can own 50% without any problems theyll still always be one person.

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4) BUT Formed for the purpose of doctrine applies for purposes of the 3(c)(1) exemption. For the 100 person count to the exemption, we apply the formed for the purpose of doctrine if entities were formed for the purpose of counting as just one investor, well see through it. a) If they were recently formed, no more than 40% of their assets can go into this 3(c)(1) investment 60% must be in something else, and invested elsewhere in good faith. And creative ways to get around it are unacceptable.

5) 3(c)(7) made it even easier for hedge funds: it permits a 3(c)(7) hedge fund [similar to as 3(c)(1)] to be an unlimited amount of investors , provided all of them are qualified purchasers. So a 3(c)(7) would be a fund of all qualified purchasers [expanding on 3(c)(1)s exemption of investment companies with less than 100 owners, 3(c)(7) permits exempted investment companies with an unlimited number of owners provided they are all qualified purchasers (indivs with $5 million, institutions that invest in excess of $25 mill). An integration exemption permits parallel trading of a 3(c)(1) and 3(c)(7) (clone funds): a) Any individual who has more than $5,000,000 overall, or b) Any institution that invests $25,000,000. 6) In order to permit 3(c)(1) to work with 3(c)(7) properly, we statutorily permit clone funds you can have a 3(c)(1) and a 3(c)(7) together without them being integrated its a specific exception to integration. This permits you to have your 100 any person 3(c)(1), and run a 3(c)(7) of all qualifieds on top of it as clone fund. 7) Recall however that two years later Long Term Capital (hedge fund) almost single handedly brought down the securities markets. 8) BUT Integration : applies to (3)(c)(1) if you try to organize several different 3(c)(1)s to get around the 100 person rule, they will be treated as one 3(c)(1) and now you have exceeded the number of investors allowed. a)

Cloning Funds Exception: it is permissible to organize a 3(c)(1) and a 3(c)(7) that trade identically. Normally that would violate integration, but its ok in this particular instance. This is the mechanism by which you can have your 100 person 3(c)(1) and unlimited amount of qualified investors above it.

d.

4 Types of Permissible REGISTERED Investment Companies: You must be one of these two types of companies if you want to operate as a registered investment company: 1) Unit Investment Trust (UIT) [Often called a bond fund, its one of two types of permitted registered investment companies. UITs are characterized by a static, unmanaged portfolios, that are readily redeemable under forward NAV pricing] : often times called a bond fund. a)

Must be a static portfolio on the day you form the fund, you must add to it the shares that are to be included in it, and thats it its not managed, you cant trade, you cant take things our or add.

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b) You must be ready, willing, and able to redeem it for the investors. The investors must be able to get their money back whenever they feel like it. c)

Forward Pricing: Redemption must occur at the price of closing that day (NAV (Net Asset Value) if you call to redeem at 10AM, they will redeem you at closing at whatever price its at. If you call at 4:01PM, you will get redeemed at the closing price for the next day.

2) Management Company [Often called a mutual fund, its one of two permissible types of registered investment companies. They are actively managed funds, with two main types: open end (readily redeemable at forward NAV pricing, with no market for them) and closed end (not redeemable / illiquid, developed market for them, permits long term investment strategy)] Sells shares in the fund to get money, and then buys and sells stocks every day it actually manages the portfolio. This is true mutual fund. a)

Open End Fund : you must stand ready and willing to redeem securities at the NAV under forward pricing. There is no market for open ended funds because you can redeem them whenever you want. This creates a problem, since they must always be liquid since they worry about redemption.

b) Closed End Fund : they cannot redeem their shares, so they are totally illiquid. But of course, there is a massive market for them. But the lack of redemption permits them to create more long term investment strategies (no worry about liquidity), since they dont worry about investment. 3) If you want to call yourself a diversified management company (by statute) [A Management company whereby not more than 5% of management companys assets are in a single issuer, AND the management company cant own more than 10% of any single issuer]. : a) No more than 5% of your assets can be in a single issuer AND b) You cant own more than 10% of a single company e. 7 The Registration Requirements: You cannot operate an investment company (so its good to escape the definition by using the exceptions) unless you register with the SEC as a licensed investment company (costs much time and money). 1) Registration as an investment company is wholly separate from registration to do a securities offering this means that you first need to register the investment company under the 40 Act, and then you need to register under 33 Act to do your offering of securities in the fund itself. 2) You cannot even organize for registration unless the sponsors put up $100,000 this isnt for amateurs.

f.

Once you have a registered investment company, there are tons of rules:
1) The board of the investment company a) If youve been convicted of a felony in the last 10 years, you cannot be on the board (unless you go to the SEC for a pardon)

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2) 3) 4) 5) 6) 7) 8) 9) 3.

b) The majority of directors must be unaffiliated with the sponsor This is because everything is contracted to the management company, and we dont want conflicts of interest. c) You must use outside brokers to make sure the sponsor wouldnt just churn the fund for commissions. You cant borrow money except in limited circumstances we dont want the fund to be leveraged You cant do short sales You must make it clear to investors what your investing policies and plans are The contract with the management company cant be for more than 2 years we dont want locking up of contracts. Management fees are regulated by statute (contrast with hedge fund where they can take whatever commissions or management fees they want). It is illegal for investment funds to take a portion of the gain (otherwise, they would make speculative investments since they make money either way). Note however that hedge funds can do whatever they want. Commissions on buy-ins are heavily regulated (commissions get charged on buy in with a load fund, but not on no load fund). Amount of money they can spend on ads is regulated.

Investment Advisors Act of 1940 (Advisors Act) [Subject to exceptions, it regulates anyone who, for value, gives investment advice as to the purchase and sale of securities. The Act is a regulatory statute, most notably prohibiting contingent fees based on performance.]
a. First thing, it has to be related to securities which brings us back to definition of securities. Advice on sale of crude oil or real estate is not investment advisor but advice on something like variable insurance policies is gray area. b.

The acts work together if you have a client which is registered under the 40 act, you yourself must register as an investment advisor no matter what (contrast with people who escape 40 act registration)
Exemptions: 1) Any investment advisor whose clients are all insurance companies 2) Any investment advisor with less than 15 clients, and does not hold himself out of the public as an investment advisor. If you put an ad in the paper or your name in your lobby, you must register. a. Note that one Hedge fund with 100 members is still one client. RELEVANCE? 3) Banks are exempted by statute, so are lawyers and accountants provided they are giving the advice in the course of their profession. 4) Anyone who advises a charitable organization is exempt. 5) Publishers of bona fide publication of general circulation is exempted but there is a concern for the Lowell Case if you give out your advice in a newsletter, you may not be exempted depending on how you interpret it.

c.

d. Investment advisors cannot collect payment based on performance of advised investments.

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e. Despite registration requirements, there is little in the way of licensing requirements must be over 18, but no other restrictions. f. If you have more than $25 million under management as advisor, you must register with the SEC. If less, you register with a state obvious exception if any of your clients are registered investment companies.

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3(a)(9)...........................................................35 4(1) Exemption.........................................33 Aborted Seller Doctrine...............................48 Abusive Practices.........................................45 Access...........................................................21 Accredited Investor......................................22 Adler.............................................................54 Affiliate........................................................31 Aggregation..................................................22 Aider and Abettor.........................................57 Basic v. Levinson.........................................16 Best Efforts...................................................12 Blank Check.................................................14 Blue Chip Stamps.........................................48 Blue Sky Laws...............................................2 Brightline Test..............................................57 Broker / Dealers...........................................45 Broker/ Dealers..............................................1 Buried Materiality........................................16 Carpenter......................................................53 Carter Wallace..............................................49 Central Bank of Denver...............................57 certificate of designation................................3 Chiarella.......................................................52 clone funds...................................................61 Closed End Fund..........................................62 comment letter..............................................12 common law fraud.......................................38 Commonality..................................................6 consistent period..........................................13 Control Person..............................................31 Control Person Liability...............................43 Convertible Stock.........................................34 Corporate Spinoffs.......................................35 Creation of a Separate Security.....................9 Damages.......................................................41 Debt................................................................3 directed selling efforts..................................28 Dirks.............................................................54 diversified management company...............62 Due Diligence Defense................................40 Economic Reality...........................................4 EDGAR........................................................45 Efforts of Others.............................................5 Electrician case............................................55 Equity.............................................................3

Exchange Offerings......................................35 Exempted Securities.....................................37 Expectations of Profit....................................4 Experts..........................................................40 Family Resemblance Test..............................8 Fifth Avenue Coach Lines...........................60 Firm Commitment........................................12 For Value......................................................34 Foreign Corrupt Practices............................16 Forman...........................................................4 Formed for the purpose of doctrine.............61 Formed for the Purpose Of Doctrine...........22 Fraud on the Market Theory........................49 General Obligation bonds..............................1 Globus..........................................................39 Gun Jumping................................................12 Gustafson......................................................42 hedge funds..................................................60 Hochfelder....................................................50 Hocking v. Dubois.........................................8 Holding Company Exception.......................59 Horizontal Commonality...............................6 Howey............................................................3 In Re Carter & Johnson................................58 In Re Financial Corp. of America Shareholders Lit.......................................49 in registration...............................................12 individual investor..........................................6 Initial Public Offering....................................1 Insider Trading.............................................51 Integration....................................................18 International Brotherhood of Teamsters........5 Internet.........................................................29 Intrastate Exemption....................................19 Investment Advisors Act of 1940............2, 63 Investment Club / Exemption......................60 Investment Company...................................59 Investment Company Act of 1940...........2, 59 Investment Consumption Test.......................4 investment contract........................................3 investment decision......................................34 investor notice..............................................16 Joint and Several..........................................39 Kern..............................................................58 Koscot.............................................................7 Koscot Interplanetary.....................................5

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Landreth v. Landreth......................................9 Life Partners...................................................5 LLCs.............................................................5 Management Company................................62 Margin Trading............................................45 Marine Bank...................................................4 Marine Bank vs. Weaver................................7 Matassarin v. Lynch.......................................7 material.........................................................52 Materiality....................................................15 Mergers.........................................................36 Mini-Registration.........................................27 Misappropriation Theory.............................53 Municipal Bonds............................................1 n connection with the sale of a security.......48 NASD...........................................................45 National Student Marketing.........................58 Notes as a Security.........................................8 OHagan.......................................................53 Offshore Offerings.......................................28 Open End Fund............................................62 order of investigation...................................44 Partnership Interests.......................................5 preliminary investigation.............................44 preliminary prospectus.................................13 Primary.........................................................56 Primary Offering............................................1 Private Placement Exemption......................20 Privity...........................................................39 prospectus.....................................................11 Proxy Regulation..........................................47 PSLRA.........................................................50 public companies..........................................46 Public Offering...............................................1 Purchaser Representative.............................23 quiet period...................................................13 Ralston Purina..............................................21 Real Estate......................................................8 Registration..................................................10 Regulation A................................................27 Regulation D................................................21 Regulation F(d)............................................51 Regulation S.................................................28 Regulatory Scheme........................................7 reporting companies.....................................46 Respondeat Superior....................................43

Restricted Securities.....................................30 Revenue bonds...............................................1 Reves v. Earnst and Young............................8 Rule 10b-5....................................................47 Rule 10b-5-1.................................................54 Rule 10b-5-2.................................................53 Rule 135.......................................................13 Rule 144.......................................................31 Rule 144a.....................................................33 Rule 145.......................................................36 Rule 147.......................................................20 Rule 14e-3....................................................52 Rule 155.......................................................26 Rule 176.......................................................41 Rule 508.......................................................26 sale of business doctrine................................9 Sante Fe........................................................50 Schlitz...........................................................16 Schritzer.......................................................55 scienter.........................................................49 SEC vs. Loeb, Rhoades................................12 Secondary.....................................................56 Secondary Distribution................................29 Secondary Offering........................................1 Secondary Trading.........................................1 Securities Act of 1933....................................2 Securities Exchange Act of 1934...................2 Shelf Filings.................................................14 Short swing trading......................................47 Small business initiatives.............................21 Smith v. Gross................................................7 Sophistication...............................................21 state of incorporation...................................35 Statutory Underwriter..................................29 Stock Dividends...........................................34 Substantial Participation Test......................57 target.............................................................44 Temporary Insiders......................................53 Tender offer..................................................52 Texas Gulf Sulfur.........................................49 The 10% Test...............................................60 Tipper-Tippee Liability................................54 TSC Industries..............................................16 Uniqueness.....................................................7 Unit Investment Trust..................................61 vertical commonality.....................................6

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view to distribution......................................30 Virtual Stock Exchange.................................7 Wals vs. Foxhill.............................................6 Weiglos.........................................................16 Wells Submission.........................................44 Wheeling Pittsburg Steel..............................44 Williams Act................................................47 Withdrew and informed SEC.......................41 Wolfson........................................................31 Wright v. E&Y.............................................57 34 Act..........................................................45 10................................................................47 11 Registration Statement Liability...........39 12 Liability.................................................41 12(a)(1).......................................................42

12(a)(2).......................................................42 16(a)...........................................................47 16(b.............................................................47 17\................................................................... The SEC Liability Section......................43 2(a)(11).......................................................29 3(a)(11).......................................................19 3(c)(1).........................................................60 3(c)(7).........................................................61 4-2...............................................................20 4(1).............................................................19 504..............................................................24 505..............................................................24 506..............................................................25

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