1
Securities Regulation
Professor Bradford
Spring 2011
Exam Answer Outline
The following answer outlines are not intended to be model answers, nor are
they intended to include every issue students discussed. They merely
attempt to identify the major issues in each question and some of the
problems or questions arising under each issue. They should provide a
pretty good idea of the kinds of things I was looking for. In some cases, the
result is unclear; the position taken by the answer outline is not necessa rily
the only justifiable conclusion.
I graded each question separately. Those grades appear on your printed
exam. To determine your overall average, each question was then weighted
in accordance with the time allocated to that question. The following
distribution will give you some idea how you did in comparison to the rest
of the class:
Question
Question
Question
Question
Question
Question
Question
Question
1:
2:
3:
4:
5:
6:
7:
8:
Range
Range
Range
Range
Range
Range
Range
Range
4-9;
4-9;
3-9;
0-9;
2-9;
0-7;
0-9;
0-9;
Average
Average
Average
Average
Average
Average
Average
Average
=
=
=
=
=
=
=
=
6.93
5.67
6.93
5.81
5.93
4.19
5.41
5.63
Total (of unadjusted exam scores, not final grades): Range 2.50-8.03;
Average = 5.72
All of these grades are on the usual law school scale, with 9 being an A+ and 0 being an
F.
If you have any questions about the exam or your performance on the exam,
feel free to contact me to talk about it.
2
Question 1
Delta may sell to Sally.
Every purchaser in a Rule 506 offering “who is not an accredited investor”
must meet a sophistication test—either the purchaser or her purchaser
representative must have “such knowledge and experience in financial and
business matters that he is capable of evaluating the merits and ris ks of the
prospective investment.” Rule 506(b)(2)(ii). Sally, a fourth grade dropout,
probably doesn’t meet this requirement. But this requirement does not apply
to accredited investors. Sally is an accredited investor under Rule 501(a)(5);
as a result of her lottery win, her net worth at the time of purchase exceeds
$1,000,000.
Since Sally doesn’t have to meet this test, it’s irrelevant whether her advisor,
Bright, could qualify as a purchaser representative and meet the test on her
behalf.
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Question 2
Rule 10b-5 imposes liability for, among other things, false or misleading
statements made in connection with the purchase or sale of a security.
False Statement No. 1: “We Don’t Irradiate…”
The CEO made a deliberately false statement to Green in connection with
his purchase, falsely stating that Viande did not irradiate its meat. The CEO
knew the truth, so scienter is not an issue. But for this false statement,
Green would not have bought the stock, so transaction causation is
established. However, there are two key issues with respect to 10b-5 liability
with respect to this statement.
Materiality
The first issue is materiality. Viande is liable only if the statement is false as
to a material fact—defined as one as to which there is a substantial
likelihood that a reasonable investor would consider important in deciding
whether to purchase the stock. TSC Industries. Without question, Green
considered the irradiation statement important and would not have bought
the stock if he had known the truth.
But, even in face-to-face transactions, the test is an objective one: would a
reasonable investor consider it important. The answer is probably no.
Irradiation only accounts for 3% of Viande total sales and income and, if
it’s perfectly safe, it poses no risk to Viande. (The damages relate to bad
equipment, not the irradiation process.) However, if there are enough
people who feel like Green and Safe Earth, that could make it material.
Even though there’s no risk of damages related to harm, using irradiation
could cause people to quit buying from Viande, and thus hurt its bottom
line. This depends on how big an issue irradiation is.
Loss Causation
Even if the irradiation statement is material, there’s an issue of loss
causation. Viande is liable only if the subject of the false statement —
irradiation—is related to the loss. Here the loss results from viral infection
of the equipment, not from irradiation. But the equipment affected was used
only for the irradiated meat. If Green’ statement had been true, there would
have been no irradiation equipment to be infected. The question is whether
the cause of the damages is sufficiently related to the subject of the false
statement, irradiation.
False Statement No. 2: No Complaints/Safe M eat
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There’s a second possible misleading statement. In the 10-K, Viande said
they never had a substantiated consumer complaint. A t the time of the 10K, that statement was true. But, by the time Green purchased, Viande (and
the CEO) knew the statement was no longer true.
Duty to Correct/Update
In some jurisdictions, there is a duty to update —if the statement is still
being used in the market, the company must update it to reflect the new
information, even if it was true at the time. Time Warner. Viande didn’t do
that here, so it could be liable in those jurisdictions.
Even jurisdictions that don’t accept the duty to update do accept a duty to
correct a statement that was not true when made. Gallagher. The statement
that “Viande has never had a substantiated consumer complaint” about
safety was true when made, and therefore not subject to any duty to correct.
Viande also said it had “high-quality meats” and a reputation for safety. If
the viral infection was already a problem as of June 1, even though
complaints had not yet been received, then arguably the statement about
“high-quality meats” was already false. Its meats were not high-quality or
safe at the time.
Other Requirements
If there is a duty to disclose the problems, the omitted information is clearly
material, given the size of the damage risk. This assumes, of course, that
the problem was not publicly known. If the illnesses were public, the “total
mix” of information would not be materially misleading.
Viande acted with scienter because it knew the truth. Green must show
transaction causation. He read the 10-K before buying. It is not clear
whether he focused on the safety of the meat and the lack of consumer
complaints, but it is clear that he would not have purchased if he had been
aware of the illness problem. If he can’t show reliance, it’s unclear whether
he can use the fraud on the market presumption. We don’t know anything
about the efficiency of the market for Viande’s shares. And we don’t even
know if the price Green paid was based on the ma rket price; he clearly
didn’t purchase on the market. Loss causation is established, because the
loss relates directly to the safety issue and the consumer complaints.
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Question 3
All of the offerees in a Rule 147 offering must be resident in the state of
which the issuer, Seller, is a resident. Rule 147(d). In this case, that would
be New York.
For a corporation like Alpha, the state of residence of an offeree is the state
of its principal office. Rule 147(d)(1). Alpha’s principal office is in New
York, so it meets this requirement. It doesn’t matter where Alpha is
incorporated or where it does business. For a partnership like Beta,
residence is also based on its principal office. Rule 147(d)(1). Beta’s
principal office is in New York, so it qualifies as well.
However, there is an exception. If the corporation or partnership is
organized “for the specific purpose of acquiring” the Rule 147 issue, it
doesn’t meet the residency requirement unless all of its beneficial owners
are residents. Rule 147(d)(3). This clearly wouldn’t apply to Beta, as it has
been in business for 20 years; it wasn’t created for the purpose of this
offering. It’s unclear whether Alpha would be subject to this provision or, if
it is, what the residence of its beneficial owners is.
Thus, Beta clearly is an acceptable purchaser. Alpha probably is, but more
information is needed to determine whether 147(d)(3) applies and, if it
does, whether Alpha is acceptable.
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Question 4
Part (1)
Section 5(b)(1) of the Securities Act makes it unlawful to transmit any
prospectus with respect to which a registration statement has been filed,
unless that prospectus meets the requirements of section 10. A confirmation
of sale clearly falls within the general definition of “prospectus” in §
2(a)(10). It is written and it “confirms the sale of any security.” The
confirmation Dan sent to Carla would not fall within the § 2(a)(10)(a)
exception to that definition because Carla did not receive a § 10(a)
prospectus prior to or at the same time as the confirmation. And the
confirmation does not meet the requirements of section 10; section 10(a)
covers only the final prospectus and the SEC has not approved the
confirmation under its section 10(b) authority. Dan is not exempted from
the requirements of § 5(b)(1) merely because he didn’t participate in Acme’s
offering; nothing in § 5 limits its application to participants.
Section 4(4) exempts brokers’ transactions executed upon customer’s orders.
Dan is a broker, but § 4(4) doesn’t apply here because he solicited the order
from Carla.
Section 4(3) exempts dealers’ transactions. A broker is a dealer. § 2(a)(12).
But there are exceptions to the § 4(3) exemption. Transactions occurring less
than 40 days after effectiveness (90 days in the case of an initial registered
offering) are not exempted. This was Acme’s first registered offering, and
Carla’s transaction was within 90 days of the January 3 effective date. Thus,
§ 4(4) is also not available.
Part (2)
Rule 172(a)(1) exempts written confirmations from § 5(b)(1), provided that
the conditions of subsection (c) are satisfied. Acme meets the subsection (c)
conditions. Acme’s registration statement was effective and not the subject
of any stop-order proceeding or examination. (c)(1). Neither Acme nor
anyone involved in the offering was the subject of a section 8A proceeding.
(c)(2). Acme has filed a final prospectus, (c)(3), although (c)(4) says this
requirement wouldn’t apply to someone like Dan in any event. And, as far
as we know, Acme doesn’t fall into any of the exclusions in subsection (d).
Thus, the Rule 172(a)(1) exemption from 5(b)(1) is available and Dan’s
mailing of the confirmation is not a violation.
Rule 174 reduces the 90-day limit in some circumstances, but it does not
apply here. Acme is not a reporting company, Rule 174(b), the security is
not listed on an exchange or NASDAQ, Rule 174(d), and it does not
otherwise fit into any of the Rule 174 exceptions.
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Question 5
Shelf registration is available only if the offering fits int o one of the
categories of Rule 415(a)(1). This offering would appear to fit within
subsection (ix): the offering will be commenced promptly upon
effectiveness, and will be made on a continuous basis for a period in excess
of 30 days.
However, Rule 415(a)(4) says that an at the market offering of equity
securities by the issuer must come within subsection (x) to be eligible for
shelf registration. If (a)(4) applies, subsection (ix) won’t work. Star is
offering common stock so this is clearly an offering of equity securities, and
the offering is by Star, the issuer. Subsection (a)(4) defines an at the market
offering as one “into an existing trading market for outstanding shares of
the same class at other than a fixed price.” This is clearly an at the market
offering. Star’s common stock is already traded on the New York Stock
Exchange. Star will be selling the same class of common stock through the
Exchange at the market price on the date of sale —clearly not a fixed price.
Since this is an at the market offering, it must fall within subsection
(a)(1)(x) or it is not eligible for shelf registration. To fall within subsection
(x), the offering must be qualified to be registered on Form S -3. The other
requirements of (x) are met because these securities will b e offered on a
continuous basis by the registrant.
Star meets the registrant requirements of Form S-3. It is organized under
the laws of a U.S. state, Delaware, and its principal, indeed its only,
business operations are in the U.S. A1. Its common stock is registered under
the Exchange Act A2. It has been registered for more than 12 months. A3a.
It has filed all its reports in a timely manner for the last 12 months. A3b.
And it has never had any kind of default that would disqualify it under A5.
Star also meets the transaction requirements of Form S-3. It doesn’t fall
within B1 because the aggregate market value of common equity held by
non-affiliates is not $75 million. Its public float is $76 million, but only $60
million is held by non-affiliates. The only other potentially applicable
transaction requirement is B6. Star has a class of equity securities registered
on a national securities exchange, so it meets 6(c). And it does not appear to
be a shell company. Further, the aggregate market value of sec urities to be
sold during the 12 months of the offering is not more than 1/3 of the
market value held by non-affiliates. As stated earlier, non-affiliates hold $60
million worth of the common equity, and Star proposes to sell only $20
million, which is exactly one-third. Therefore, Star is eligible to use Form S3.
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As to the other requirements of Rule 415, subsection (a)(2) doesn’t apply
because it doesn’t cover offerings in paragraph (a)(1)(x). Rule 415(a)(3)
would require Star to furnish the required undertakings. And Star doesn’t
have to worry about (a)(5) and (a)(6) because it’s going to sell everything
within a year. As long as Star isn’t disqualified by subsection (b), and it
doesn’t appear to be, this offering is eligible for shelf registration.
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Question 6
It depends on the nature of the conversion right. If the preferred stock is
not immediately convertible into common, Mars has not violated the
Securities Act. If it is immediately convertible, Mars has violated the Act.
Mars registered the preferred stock, so it has no problem with respect to the
sale of the preferred.
Section 2(a)(3) of the Securities Act says that the transfer of a right to
convert one security into a second security is not an offer or sale of the
second security as long as the conversion right “cannot be exercised until
some future date.” If the conversion right could not be exercised
immediately, this provision applies and there was no offer or sale of the
common when the preferred was originally sold. If the shares were
immediately convertible then, by negative implication, the original offering
was also an offering of the common. Since the common stock was not
registered, this offering would violate section 5 as to the common.
In either case, there was a sale of the common shares when the holders of
the preferred converted their shares to common stock. Section 2(a)(3) says
that the exercise of a conversion right is a sale of the second security. And
the conversion falls into the general definition o f a sale—the preferred
holders gave up value, the preferred shares, to get the common. Absent an
exemption, Mars would have to register these sales. However, these
conversions fall within the section 3(a)(9) exemption. Mars, the issuer of
both of these securities, is exchanging a security exclusively with its existing
security holders. It’s exclusively an exchange; shareholders don’t have to pay
any additional consideration. And Mars isn’t soliciting the exchange, so no
one is being paid remuneration for solicitation. Since 3(a)(9) applies, the
conversion does not violate section 5.
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Question 7
There are only two resale safe harbors that might apply, Rule 144 and 144A.
Rule 144A
All of the potential purchasers are qualified institutional buyers, as required
by Rule 144A(d)(1). The four manufacturing companies all own or invest in
at least $100 million of securities, and none of those securities are of
Nortex or its affiliates, Rule 144A(a)(1)(i), and they’re all corporations Rule
144A(a)(1)(i)(H). The fifth purchaser only has $15 million of its own
investments, but, since it’s a dealer, which includes a broker, it qualifies
under subsection (a)(1)(ii), which only requires $10 million. However, Rule
144A is not available, because of subsection (d)(3)(i). The Nortex Class A
common stock, the security to be sold is listed on the New York Stock
Exchange, a national securities exchange. Therefore, Rule 144A is
unavailable.
Rule 144
Seller is an affiliate of Nortex, so his resales must meet all of the conditions
of Rule 144. Rule 144(b)(2).
The current public information requirement in subsection (c) (1) is met.
Nortex has been a reporting company for more than 90 days and it is
current in all its filed reports.
These securities were sold pursuant to Rule 506, so they ’re restricted
securities. Rule 144(a)(3)(ii). Therefore, they are subject to the holding
period in 144(d). Nortex is a reporting company, so the holding period is 6
months. Rule 144(d)(1)(i). That period runs not from when Seller originally
acquired the securities but, since he paid with a non -recourse note, from
when he paid off the note. Rule 144(d)(1)(iii);(d)(2). Thus, Seller will have
to wait at least another month before he sells these securities.
There is a limitation on the amount Seller may sell —the greater of 1% of
the class outstanding or the average weekly trading volume. Rule 144(e)(1).
One percent of the class outstanding would be 1.0 million, since we look
only at the Class A shares, not all outstanding shares. The average weekly
trading volume is only 900,000 shares. Therefore, the limit in any three
month period is only 1.0 million. Seller will have to wait 3 months to sell
the remaining 100,000 shares.
The shares must be sold in a broker’s transaction, Rule 144(f), and
solicitation is generally not allowed. See Rule 144(g)(3). Seller is using a
broker and the question says his broker did not solicit the purchasers in any
way, so that requirement is met.
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Finally, since Seller is selling more than 5,000 shares and the sale price
exceeds $50,000 (either one would be enough), he must file a Form 144 with
the SEC. Rule 144(h)(1).
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Question 8
Section 12(a)(1) of the Securities Act makes liable anyone who “offers or
sells a security in violation of section 5.” Without question, the offering
violated section 5. It was unregistered and there was no exemption. Thus,
the Association would be liable to anyone to whom it offered or sold .
However, the Association is liable only if it offered or sold to the
individuals whose transactions it helped facilitate —to those “purchasing
from” it. § 12(a).
An offer is “every attempt or offer to dispose of, or solicitation of an offer
to buy . . . for value.” Securities Act § 2(a)(3). The Association clearly
solicited the purchasers whose purchases it facilitated. The case indicates it
urged people to buy the bonds, and it also helped them do so. The real
question is whether it did so for value.
Pinter v. Dahl says that one is a “seller” for section 12(a)(1) purposes only if
one is the owner from whom title passes or one “solicits the purchase,
motivated at least in part by a desire to serve his own financial interests or
those of the securities owner.” The Association is not the owner from whom
title passed. Although the Association facilitate d the delivery of cash from
the buyers and the securities from the seller, title appears to have passed
directly from the Republic of China to the eventual purchasers. Thus, the
Association is a seller only if it fits into the second test.
The Association received no commission or other consideration, either from
the Republic of China or from purchasers, for its actions on behalf of the
Republic of China. Thus, it is clearly not soliciting these people to serve its
own financial interests.
However, Pinter says neither a share of the profits nor a commission,
although either would meet the “value” requirement, is essential. A person
who solicits the buyer to serve the financial interests of the owner is a seller
even though that person won’t participate in any benefits the owner
receives. The Association solicited the purchases, not to benefit the buyers,
but for patriotic reasons—to support the Republic of China. Thus, it was
doing so to serve the interests of the owner, and would be a seller liable
under section 12(a)(1).
If the Association is liable, the purchasers may recover the price they paid
for the bonds. § 12(a). If they have already sold the bonds, they may recov er
damages. Id. In neither case must they prove that the section 5 violation
caused them any harm