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REGULATION
7
Agency, Bankruptcy, Securities, CPA Legal Liability, and Capyrights & Patents
1.
Agency
2.
Bankruptcy
3.
Securities regulation
4.
CPA legal liability
53
5.
Antitrust law
59
6.
Copyrights and patents
67
7.
Class questions
71
3
"
16
,
,
39
Becker Professional Education
Regulation 7
I CPA Exam
Review
NOTES
R7-2
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Becker Professional Education
I CPA Exam
Regulation 7
Review
AGENCY
I.
CREATION OF THE AGENCY RELATIONSHIP
A.
Introduction
Agency is a legal relationship in which one person or entity (the principal) appoints another
person or entity (the agent) to act on his behalf.
B.
Requisites for Creation
1.
Principal with Capacity and Consent
As a general rule, all that is required to create an agency relationship is a principal with
contractual capacity (I.e., not a minor and not incompetent) and consent of the parties
(I.e., the parties agree to act as principal and agent).
a.
b.
Writing Generally Not Required-Unless to Buy or Sell Land or Impossible
to Perform in One Year
(1)
A writing generally is not required to create an agency relationship, even if
the contract that the agent is to enter on the principal's behalf must be
evidenced by a writing under the Statute of Frauds.
(2)
However, many states require a written agency agreement if the agent is to
buy or sell an interest in land for the principal.
(3)
Note that a contract to find a buyer or seller (normal real estate broker's
agreement) and a contract to build a house are contracts for services. An
oral agency involving such transactions is valid.
(4)
Agency agreements that cannot be performed in one year must be
evidenced by a writing.
Agent Need Not Have Capacity-Minors Can Be Agents
Only the principal must be competent. The agent need not have capacity. Thus,
a minor or mentally incompetent person can be appointed as an agent.
c.
Consideration Not Required
Consideration is not required to form an agency relationship.
PASS KEY
The examiners often ask what is necessary to create an agency. Generally, all you need is consent and a principal
with capacity. A writing is necessary only if the agent will enter into land sale contracts. Thus, an answer that says a
writing is required or the agent's authority must be signed by the principal usually is wrong.
2.
Power of Attorney-Written Authorization of Agency
•
.., ..
..
a.
A power of attorney is a written authorization of agency.
b.
The agent under a power of attorney is referred to as an "attorney in fact." But
the agent need not be a lawyer. It just means that the agent has the power to act
on behalf of the principal.
c.
Generally only the principal is required to sign the power of attorney. There is no
requirement that the agent sign the instrument.
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d.
C.
I CPA Exam Review
The agent's authority is normally limited to specific transactions.
Rights and Duties Between Principal and Agent
Certain duties are implied in every agency relationship.
1.
Duties of Agent to Principal
The agent has whatever duties are expressly stated in his contract. The agent also
owes the following three duties:
a.
Duty of Loyalty-Act Solely in Principal's Interest
(1)
An agent owes her principal a duty of loyalty, i.e., the agent must act solely
in the principal's interest in connection with the agency.
(2)
An agent breaches this duty when she has interests adverse to the
principal (e.g., agent obtains kickbacks from a third party).
EXAM PLE
Petshop hired Andy as its store manager and gave Andy authority to purchase pets for the
store. Andy occasionally purchased dogs from Tremendous Dogs. When Andy bought dogs
from Tremendous, it paid Andy 5% of the purchase price as incentive to do more business.
Pets hop was unaware of the payments, which Andy kept. Andy has breached his duty of
loyalty and can be forced to turn over his profit to Petshop.
b.
Duty of Obedience-Obey Reasonable Instructions
An agent must obey all reasonable directions of his principal.
EXAMPLE
Paul hires Audrey as his purchasing agent for televisions, but instructs Audrey not to disclose to
sellers that she is working for Paul. If Audrey discloses to a seller that she is working for Paul,
she breaches her duty of obedience and will be liable to Paul for any damages the disclosure
caused.
c.
Duty of Reasonable Care-Liable if Negligent
An agent owes her principal a duty to carry out the agency with reasonable care
(i.e., the duty not to be negligent).
d.
Duty to Account
Unless otherwise agreed, the agent has a duty to account to the principal for all
property and money received and paid out when acting on behalf of the principal.
The agent cannot commingle the principal's property with the agent's property.
e.
Subagent
If an agent is authorized to hire a subagent, the subagent owes a duty of care to
both the agent and the principal.
.7.4
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2.
I CPA Exam Review
Regulation 7
Principal's Remedies
If an agent breaches the duties she owes to her principal, the principal can recover
damages from the agent:
a.
Tort Damages
The principal can recover tort damages from the agent if the agent negligently or
intentionally breached a duty owed to the principal.
b.
Contract Damages
If the agent was compensated, the principal can collect contract damages. If the
agent did not receive consideration, a contract was not formed and so contract
damages are not available.
c.
Recovery of Secret Profits
If the agent obtained a secret profit, as in the example in a., above, the principal
can recover the secret profit, usually by imposing a constructive trust on the
profit.
d.
Withhold Compensation
If the agent committed an intentional tort or intentionally breached her duty to her
principal, the principal may refuse to pay the agent.
3.
Duties of Principal to Agent
In addition to any duties expressed in the agency agreement, the principal owes the
agent the following duties:
a.
Compensation
Unless the agent has agreed to act gratuitously, the principal has an implied duty
to give the agent reasonable compensation.
b.
Reimbursement
The principal also has an implied duty to reimburse (i.e., indemnify) the agent for
all expenses incurred in carrying out the agency.
c.
4.
Remedies of the Agent
(1)
If the principal breaches her duties to the agent, the agent can bring an
action against the principal for any damages caused.
(2)
The agent has a duty to mitigate damages (e.g., a wrongfully fired agent
must seek comparable work to replace lost income).
Power to Terminate Relationship-Generally Terminable at Will
Since an agency relationship is consensual, either party generally has the power to
terminate the relationship at any time. However, the parties don't necessarily have the
right to terminate at any lime.
EXAMPLE
Porth os hires Athos as his purchasing agent for nine months, at a salary of $2,000 per month. Either
party can terminate the agency the next day, but a wrongful termination will be a breach of contract.
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Regulation 7
•
a.
I CPA Exam Review
Exception-Agency Coupled with an Interest
(1)
The principal cannot terminate an agency coupled with an interest. Only
the agent can terminate an agency coupled with an interest.
(2)
This arises where the agent has an interest in the subject matter of the
agency, such as where the agency power is given as security. In effect,
the agent has paid for the right to be appointed as the agent, usually by
giving credit.
(3)
Death, incapacity or bankruptcy of the principal will not end an agency
coupled with an interest.
EXAMPLE
P borrows $20,000 from AI promising to pay A within a year and appointing A as his agent to
sell Blackacre if P fails to pay. A's agency is coupled with an interest.
EXAMPLE
P hires A to sell Blackacre in exchange for 5% commission. P has the power to terminate the
agency at any time because A has not acquired an interest in Blackacre.
II.
AGENT'S POWER TO CONTRACTUALLY BIND PRINCIPAL
A.
B.
1*.'1
Introduction
1.
An agency relationship arises when the principal appoints an agent to act on his behalf.
By this appointment, the agent can bind the principal in contract.
2.
However, the power to contractually bind the principal can arise in several situations
where a true agency relationship does not exist-a principal may be liable even though
no consensual agency relationship was created.
3.
Agency power can arise through:
a.
A grant of actual authority,
b.
Apparent authority or estoppel, or
c.
Ratification.
Actual Authority
Actual authority (sometimes called "real authority" or simply "authority") is the authority the
agent reasonably believes he possesses because of the principal's communications to the
agent. An agent with actual authority has the power and the right to bind his principal. Actual
authority can be either express or implied.
1.
Express Actual Authority
Actual authority includes all powers that the principal expressly grants within the "four
corners" of the agency agreement.
R7-6
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2.
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Implied Actual Authority
a.
Actual authority includes not only the authority expressed in the agency
agreement, but also any other authority that the agent could reasonably believe
is implied along with the express grant.
b.
This includes the authority to do things reasonably necessary to carry out the
agency (e.g., a person hired to manage a business will usually have authority to
hire employees, buy merchandise, etc.).
c.
Implied authority may also include things not necessary or customary, but which
the principal has repeatedly allowed the agent to do.
d.
Implied authority includes the authority to handle emergencies when no other
instructions are given.
PASS KEY
The examiners have tested on the implied authority of a business manager a number of times. The
key is to remember that the manager is there to run the business, not destroy it. Thus, she has
~
authority to hire and fire employees, purchase inventory, and pay business debts. She has no implied'
authority to sell or mortgage business fixtures or other property of the principal (other than
inventory). Also remember that generally an agent does not have implied authority to borrow money
on the principal's behalf-such authority must be expressed.
'b
3.
Termination of Actual Authority Can Occur By:
a.
Act of the Parties
(1)
Termination of an agency can occur through the acts of either the principal
(a revocation) or the agent (a renunciation). Of course, the termination
could violate the parties' contract, in which case damages could be
available.
(2)
Exception: Agency Coupled with an Interest
If the agency is coupled with an interest, only the agent, not the principal,
has the power to terminate the agency relationship.
b.
c.
Accomplishment of Objective or Expiration of Stated Period
(1)
If the agency is for a limited purpose (e.g., Phil appoints Andrea to
purchase Blackacre for him), actual authority is terminated when the
objective is accomplished (i.e., Andrea purchases Blackacre).
(2)
If the agency is for a stated period (e.g., six months), actual authority is
terminated upon expiration of the period. If no time is stated, the actual
authority terminates after a reasonable time.
Termination of Actual Authority
Actual authority is terminated by the following events:
(1)
Death of either the principal or the agent;
(2)
Incapacity of the principal:
(3)
Discharge in bankruptcy of the principal;
(4)
Failure to acquire a necessary license;
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Becker Professional Education
I CPA Exam Review
(5)
Destruction of the subject matter of the agency (e.g., Paula hires Alex to
purchase an antique car, which is destroyed before it can be purchased);
or
(6)
Subsequent illegality (e.g., Paula hires Alex to purchase an antique
machine gun, but before the gun can be purchased Congress passes a law
prohibiting private ownership of machine guns).
PASS
KEY
Termination of agency by operation of law is a heavily tested issue. Be sure to memorize the
above list.
•
C.
Apparent Authority
Even though an agent might not have actual authority, there are situations where the agent
will nevertheless have the power (but not the right) to bind the principal, either because the
principal's conduct has caused third parties to reasonably believe the agent had authority or
because the principal was negligent and so will be estopped from denying that the agent had
authority. This power to bind the principal Is known as apparent authority.
1.
2.
3.
Principal's Conduct
a.
Note that apparent authority requires a holding out by the principal or negligent
inaction by the principal.
b.
The purported agent's mere representation that he is an agent is not sufficient to
establish apparent authority.
Distinguish from Actual Authority
a.
Apparent authority is based on the third party's reasonable belief that the agent
has the power to bind the principal.
b.
Actual authority arises from the agent's reasonable belief that he has the power
to bind the principal, not the third party's belief.
c.
In either case the principal is bound. However, if the agent lacked actual
authority, the principal can hold the agent liable for acting without authority.
Common Apparent Authority Situations
a.
Apparent Authority from Position
A principal who hoids another out as his agent vests the agent with the power to
enter into all transactions that a reasonable third party would believe a person in
the agent's position would have.
EXAMPLE
Pam hires Alex to manage her pet store. Alex has the apparent authority to hire and fire
employees, make deposits, etc.
R7-8
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I CPA Exam
(1)
Regulation 7
Review
Secret Limiting Instructions Not Effective
Since apparent authority is based on what the third party reasonably
believes, the principal's secret limiting instructions-while effective to limit
the agent's actual authority-are not effective to limit the agent's apparent
authority.
EXAMPLE
Pam hires Alex to manage her pet store. It is customary in the area for pet store
managers to have actual authority to purchase inventory (pets). Pam tells Alex that he
may purchase pets for the store, but may not purchase a pet for more than $200. Tom,
a dog breeder, offers to sell Pomeranian puppies to the pet store for $250 each, and
Alex accepts. Alex has apparent authority to purchase the puppies, but not actual
authority. Thus, Pam will have to pay Tom for the puppies, but can hold Alex liable for
any loss that results.
(2)
General vs. Special Agent
A general agent is an agent engaged to perform a series of transactions
involving a continuity of service. A special agent is one engaged to
perform one or more transactions not involving a continuity of service. A
general agent's apparent authority is broader than a special agent's
apparent authority.
b.
Notice Generally Required to Terminate Apparent Authority
When a principal terminates an agent's actual authority, the agent will continue to
have apparent authority to perform until the principal notifies third parties who
might have known of the agency.
(1)
Actual notice must be given to terminate apparent authority to old
customers.
(2)
Constructive notice must be given to terminate apparent authority to new
customers.
EXAMPLE
Allen has been Patty's office manager for 10 years and has regularly purchased office supplies
from Terri. Patty fires Allen, but does not notify Terri. If Allen purchases more office supplies
from Terri purportedly on Patty's behalf, Terri can make Patty pay for the supplies because of
Allen's apparent authority.
4.
Termination of Apparent Authority by Operation of Law-No Notice
a.
As a general rule, to terminate an agent's apparent authority, there must be some
act that prevents the third party in question from reasonably believing that the
agent has authority. This usually requires notice of the termination, limitation on
authority, etc.
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b.
D.
I CPA [XClm
Review
However, apparent authority is terminated by operation of law, and no notice is
required, if any of the following occur:
(i)
Death of the principal or agent;
(ii)
Incapacity of the principal; or
(iii)
The principal receives a discharge in bankruptcy.
Ratification
Ratification allows a principal to choose to become bound by a previously unauthorized act of
his agent.
1.
Requirements
a.
The agent must have indicated that he or she was acting on behalf of the
principal (if the third party did not believe the agent was acting for a principal,
there can be no ratification).
b.
All material facts must be disclosed to the principal.
c.
The principal must ratify the entire transaction-there can be no partial
ratification.
Note that ratification does not require consideration and that the principal need not
notify the third party of the ratification (since the third party already thinks he has a
contract with the principal).
2.
May Ratify Expressly or Impliedly
The principal may ratify expressly, or may ratify impiiedly by accepting the benefits of
the contract when there is an opportunity to reject them.
3.
What May Be Ratified?
Generally, any act may be ratified unless:
4.
R7-10
a.
Performance would be illegal;
b.
The third party withdraws prior to ratification; or
c.
There has been a material change of circumstance so that it would not be fair to
hold the third party liable.
Only a Disclosed Principal May Ratify
a.
Only the purported principal may ratify. The agent cannot take over the contract
for himself.
b.
Only a disclosed principal may ratify. An undisclosed principal cannot ratify.
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E.
I CPA Exam Review
Regulation 7
Contractual Liability
1.
Principal Liable if Agent Had Authority or Principal Ratified
The principal will be bound by the agent's acts if the agent acted with actual authority or
apparent authority, or if the principal ratified the transaction.
;
WILL AGENT'S ACTS BIND THE PRINCIPAL?
..
Was there express or implied
actual autharity (authority the
agent reasonably believes he/she
possesses based on his/her
;
,
YES
The principal will
be bound.
i
dealings with the principal)?
I
NO
Was there apparent authority
(authority the third party
reasonably believes the agent
YES
The principal will
be bound.
has based on the third party's
dealings with the principal)?
,
I
NO
Did the principal ratify the
contract after the agent entered
into it on the principal's behalf
;
YES
The principal will
be bound.
and before the third party
withdrew?
I
NO
The principal will not be bound.
2.
Agent's Liability
a.
Disclosed Principal-Agent Not Liable if Authorized
(1)
If the agent discloses the existence and identity of the principal (a
disclosed principal situation), the third party cannot hold an authorized
agent liable on the contract.
(2)
Every person representing himself as an agent impliedly warrants that he
has the authority he purports to have. If in fact the agent has no such
authority, the third party can hold the agent liable for any damages caused
based on breach of this implied warranty.
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righl~
reserved
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Regulation 7
b.
I-I
Partially Disclosed and Undisclosed Principal-Agent Liable
If the principal's identity is not disclosed to the third party (a partially disclosed
principai situation) or neither the existence nor the identity of the principal is
disclosed to the third party (an undisclosed principal situation), the agent is Hable
on the contract with the third party.
(1)
Third Party's Election
The third party can hold either the principal or the agent Hable if the
principal was undisclosed or partially disciosed, but not both. The third
party must elect whom to hold liable.
(2)
No Apparent Authority with an Undisclosed Principal
If the principal is undisclosed, there can be no apparent authority because
there is no holding out of the agent by the principal.
(3)
No Effect on Actual Authority
The fact that the principal is undisclosed has no effect on the agent's
actual authority since actual authority arises from the communications
between the principal and the agent.
PASS KEY
The examiners often ask about undisclosed principal situations. There are a few key points to
remember.
3.
•
The principal is bound if the agent had authority. It is irrelevant whether the principal was
disclosed, partially disclosed or undisclosed. If the agent did not have authority, the
principal is bound only if he ratifies.
•
The agent can be held personally liable if the principal is partially disclosed (identity is not
disclosed) or undisclosed (neither identity nor existence are disclosed).
Third Party's Liability
a.
Generally Only Principal Can Hold Third Party Liable
As a general rule, only the principal (not the agent) can hold the third party liable
on a contract the agent entered into on the principal's behalf, even if the
principal's existence or identity were not disclosed.
EXAMPLE
Ann entered into a contract with Top Corp. to purchase televisions on behalf of Paul. Paul
instructed Ann to enter into the contract in her own name without disclosing that she was
acting on behalf of Paul. If Top repudiates the contract, Paul may hold Top liable even though
it did not know it was dealing with Paul.
b.
Exceptions
The principal cannot hold the third party liable where:
(1)
R7-12
The principal's identity was fraudulently concealed (e.g., if the third party
indicates that he will not do business with the principal, the principal cannot
get around this by deaHng through an agent): or
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(2)
111.
Regulation 1
The performance to the principal would increase the burden on the third
party (e.g., Goodyear cannot employ a small rubber manufacturer as an
agent to enter into a rubber requirements contract without disclosing that
the contract is for Goodyear).
TORT LIABILITY
A.
In General-Respondeat Superior
1.
B.
As a general rule a principal is not Hable for the torts committed by his
agent-only the agent is liable.
•
.- .... ,-
.
2.
However, there is an exception for employers. Under the doctrine of respondeat
superior, an employer can be Habie for an employee's torts committed within the scope
of employment.
3.
This does not relieve the agent of liability. The injured person may sue both the
employer under respondeat superior and the agent.
Employer.Employee Relationship
An employer (or master) is liable only for torts of an employee (or servant) and is
usually not liable for torts of independent contractors.
1.
IIIlIIII
Right to Control Manner of Performance is Key
The most important factor in determining whether a person is an employee or an
independent contractor is the right of the principal to control the manner In which the
person performs. An employer has the right to control employees, but has littie control
over the methods used by independent contractors.
2.
Additional Factors
Where right to control is not clear, the courts look to other factors, such as whether the
worker has a business of his own, provides his own tools and facilities, length of the
employment (short or definite vs. long or indefinite), basis of compensation, and the
degree of supervision.
a.
A clear example of an employee is one who works full time for the employer,
uses the employer's facilities or tools, is compensated on a time basis, and is
subject to the supervision of the principal.
b.
A clear example of an independent contractor is one who has a calling of his own
and who uses his own facilities or toois, is hired for a particular job, is paid a
given amount for that job, and who follows his own discretion in carrying out the
job.
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'7-13
Regulation 7
•
C.
Becker Professional Education
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Scope of Employment
An employer is not liable to an injured party merely because an employee caused the injurythe injury must also have occurred within the scope ofthe employment. That is, the injury
must have occurred while the employee was working for the employer within the time and
geographic area in which the employee was to work.
1.
Activities
The conduct causing the injury need not actually have been authorized by the
employer; rather the conduct need only be:
(i)
Of the same general type the employee was hired to perform; and
(ii)
Actuated, at least in part, by a desire to serve the employer.
EXAMPLE
While a bar owner might not authorize a bouncer to beat up boisterous customers, the owner
nevertheless can be held liable if this occurs, because the conduct is of the same general nature as the
bouncer's job.
a.
b.
Intentional Torts
(1)
The employer usually is liable only for an employee's negligence and is not
liable for intentional torts, since intentional torts are seldom within the
scope of employment.
(2)
However, where the tort Is authorized or where use of force is authorized
(as with a bouncer), the employer can be liable.
Crimes
An employer generally is not liable in tort for an employee's conduct that
constitutes a serious crime (e.g., carrying an illegal weapon).
PASS KEY
The examiners often ask about a principal's liability for its agent's torts. Remember, if the agent is an
employee and committed a tort while trying to serve the principal/employer, the principal/employer
generally will be liable unless the tort was unexpected (e.g., illegal conduct).
2.
Time and Geographic Area
It is not enough simply that the conduct that caused the Injury was of the same general
type the employee was hired to perform. The conduct must also have occurred within
usual employment time and space limits.
R7-14
a.
Small detours from an employer's directions (e.g., driving a few blocks out of the
way, stopping for lunch, etc.) fall within the scope of the employment.
b.
Major detours (frolic) from an employer's directions (e.g., driving 15 miles out of
the way to attend a party) fall outside the scope of employment.
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3.
I CPA Exam Review
Regulation 7
Cannot Limit Liability by Agreement with Employee
An agreement between the employer and employee that the employer will not be liable
for employee torts does not prevent a third party from holding the employer liable. The
employer can seek reimbursement from the employee.
AN elL L A R Y MAT E R I A l
d.
(for Independent Review)
Employer Liability for Independent Contractors
1.
II!ll!IImII
~
Although the general rule is that an employer is not liable for torts
committed by independent contractors, there are certain situations where the employer
can be held liable for torts of independent contractors.
2.
For example, an employer can be liable for the torts of an independent contractor if the
employer authorized the tortious act or if the work involved an ultrahazardous activity.
3.
These exceptions are rarely tested.
o
END OF ANCIllARY MATERIAL
LIABILITY OF PRINCIPAL FOR AGENT'S TORTS
Is the agent an employee or
an independent contractor
(look chiefly to the extent of
the principal's control over
the manner and method of
the agent's performance)?
EM~
Was the act within the scope
of employment (i.e., was the
employee where he/she was
supposed to be, doing what
he/she was supposed to be
doing, with the purposes of
the employer in mind)?
The principal
is liable.
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~
INDEPENDENT
~RACTOR
Generally, the principal is not
liable for the torts of an
independent contractor.
The principal
is not liable.
R7-15
Regulation 7
Becker Professional Education
I CPA Exam
Review
BANKRUPTCY
I.
INTRODUCTION
A.
Types of Bankruptcy Cases
1.
Five Types of Bankruptcy Cases
There are five basic types of bankruptcy cases under federai law: Chapter 7liquidation; Chapter 9-municipal debt adjustment; Chapter 11-reorganization;
Chapter 12-family farmers with regular income; and Chapter 13-adjustment of debts
of individuals with regular income.
2.
I-I
3.
4.
Chapter 7 liquidation-Trustee Appointed
a.
In a Chapter 7 liquidation case, a trustee is appointed. The trustee collects the
debtor's assets, liquidates them, and uses the proceeds to payoff creditors to the
extent possible.
b.
If the debtor is an individual (or a married couple), the debtor's debts are then
discharged, with certain exceptions.
c.
If the debtor is an artificial entity (e.g., a corporation), it is dissolved. No
discharge is given but the effect is the same-the debts are wiped out.
Chapter 13 Adjustment of Debts of Individuals with Regular Income
a.
In a Chapter 13 case, the debtor repays all or a portion of his debts over a threeyear period to a maximum of a five-year period.
b.
Although there is not a liquidation, a Chapter 13 trustee oversees the handiing of
a Chapter 13 proceeding.
c.
At the conclusion of a Chapter 13 proceeding, the remaining debts of the debtor
are discharged.
Chapter 11 Reorganization-No Liquidation, Trustee Not Required
a.
In a Chapter 11 reorganization case (usually used by businesses but aiso
available to individuals), a trustee usually is not appointed.
b.
The debtor remains in possession of his or her assets and a pian of
reorganization (i.e., a plan to payoff debts at a different time and/or different
amount than originally due) is adopted.
c.
Creditors are paid to the extent possible and the business continues.
PASS KEY
The examiners often ask if a trustee is required for a particular type of bankruptcy. There are a few key points
to remember.
R7-16
•
A trustee is required for Chapter 7 and Chapter 13.
•
A trustee is not required for Chapter 11, although the court may appoint one if one is needed.
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B.
I CPA Exam Review
Regulation 7
Dismissal or Conversion of a Chapter 7 Case - The Means Test
A Chapter 7 case by an individual consumer debtor may be dismissed (or with the debtor's
consent converted to a case under Chapter 13) upon a finding that granting relief under
Chapter 7 would constitute abuse. Abuse may be determined by a specific means test or by
a more general abuse test.
1.
Calculation of Debtor's Income
To determine if the debtor has sufficient income to pay some or ail of their debts under
a Chapter 13 pian, a calculation of the debtor's income is made.
a.
Current Monthly Income - Average of 6 Months Preceding Filing
The first step is to determine the debtor's current monthly income based on the
debtor's average income over the six months prior to filing. The average monthly
income is compared to the median income for a similarly sized family in the
debtor's state (determined by the Bureau of Census).
(1)
If Equal To or Less Than State Median Income - Chapter 7 Permitted
If the debtor's average monthly income multiplied by twelve plus that of the
debtor's spouse (even if the spouses do not file jointly) is at or less than
the median income for similarly sized families in the debtor's state, the
debtor can file for Chapter 7 relief.
(2)
If Debtor's Income Exceeds State Median Income - Means Test
Applied
If the debtor's average monthly income multipiied by twelve exceeds the
median family income of similarly sized families in the debtor's state, the
court, the trustee and any other interested party (e.g., a creditor) may file a
motion to dismiss based on the "means tesr' or a general finding of abuse.
(3)
Monthly Income MUltiplied by Twelve
The monthly income figure is multiplied by 12 because median family
income for the various states is determined by the Bureau of Census on an
annual basis.
b.
Means Test
The means test is designed to determine whether the debtor has sufficient
income to repay debts using a Chapter 13 plan.
(1)
Current Monthly Income Multiplied by 60
The debtor's current monthly income (using a six-month average) is
multiplied by 60. Social security payments are not included in monthly
income and certain expenses are deductible. Sixty months is used
because this is the maximum number of months a Chapter 13 plan may
last.
(2)
If Less Than $7,025 - Chapter 7 Permitted
If the debtor's average monthly Income iess ailowable expenses multiplied
by 60 is less than $7,025, the debtor may file for Chapter 7 relief.
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Regulation 7
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(3)
I CPA Exam Review
If $11,725 or More - Presumption of Abuse
If the product is $11,725 or more, a presumption of abuse occurs. Unless
the presumption is rebutted, the debtor may not file for Chapter 7, but may
file for Chapter 13.
(4)
If Less Than $11,725, but $7,025 or More - Abuse Only if Amount
Equals 25% of Non-priority Claims
If the product is iess than $11,725, but at least $7,025, a presumption of
abuse will arise only if this amount equals at least 25% of the debtor's
unsecured claims not entitled to priority payment (unsecured claims
entitled to priority payment will be discussed later).
0..---
AN C I I I A R V MAT E R \ A l
c.
---.
(for Independent Review)
Allowable Deductions
The debtor is allowed to deduct the following from monthly income:
(1)
Living Expenses in Amounts Set by the IRS
The debtor may deduct living expenses (e.g., food, clothing, personal care,
entertainment, transportation and housing) in amounts set by the IRS.
(2)
Health and Disability Insurance and Health Savings Accounts
Expenses for health insurance costs, disability insurance costs, and health
savings account expenses are deductible for the debtor, spouse and
dependents if reasonably necessary.
(3)
Care of Elderly, Disabled, and Chronically III
Reasonable and necessary payments are deductible for the care of
household members or immediate family members, including parents,
grandparents, siblings, children, grandchildren, dependents, and
nondependent spouses in a joint case.
(4)
Expenses to Keep Debtor of Family Safe from Family Violence
Expenses are deductible that are reasonabiy necessary to keep the debtor
and family safe from family violence.
(5)
Actual Expenses to Administer a Chapter 13 Plan
If the debtor is eligible for Chapter 13, the actual expenses of administering
a Chapter 13 plan are deductible up to a maximum of 10% of the projected
plan payments.
(6)
Expenses for Dependents to Attend Elementary or High School - Up
to $1,775
The actual expenses (up to $1,775) for each dependent child under age 18
to attend elementary or high school are deductible.
(7)
1h
1/60 of Payments Due Secured Creditors
One-sixtieth of the payments due to secured creditors during the five years
after filing are deductible. This also includes past due amounts secured by
property necessary to support the debtor or the debtor's family.
R7-18
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(8)
Regulation 7
lh
1/60 of Amount of Priority Claim Payments
One-sixtieth of the amount of priority claim payments is deductible. (Priority
claims are discussed below, in the Chapter 7 material.)
2.
Rebutting the Presumption of Abuse
a.
Rebuttal by Showing Special Circumstances
The debtor may rebut the presumption of abuse by showing special
circumstances (e.g., serious illness or call to active military duty) that create
additional expenses or a need to adjust current monthly income.
b.
Additional Expense Must Place Debtor Below Threshold Amount
To rebut the presumption, the additional expenses must place the current
monthly income below the dollar amounts that trigger the presumption of abuse.
3.
Exception - No Presumption of Abuse for Disabled Veterans
A Chapter 7 case may not be dismissed or converted based on means testing if the
debtor is a disabled veteran whose indebtedness occurred primarily while he was on
active duty or performing homeland defense activities.
4.
General Abuse Test
a.
Requires Bad Faith or Totality of Circumstances Indicates Abuse
Even if the debtor qualifies for Chapter 7, relief may be denied by a showing that
the debtor acted in "bad faith" or that under the "totality of circumstances" there
is abuse.
b.
Only Raised by the Court, Trustee or Bankruptcy Administrator
If the debtor's average monthly income or the monthly income of the debtor and
debtor's spouse in a joint case is at or less than the median income in the
debtor's state, a Chapter 7 filing can only be dismissed by the general abuse test
and only by the court, trustee or bankruptcy administrator (not a creditor).
5.
Dismissal upon Conviction of Violent Crime or Drug Trafficking
A court may dismiss a Chapter 7 filing by a debtor convicted of a crime involVing
violence or drug trafficking.
o
END OF ANCILLARY MATERIAL
D.
Who May Be a Debtor
Only a person who resides, or has a place of business, in the United States is eligible to be a
debtor under the Bankruptcy Code. "Person" generally includes individuals, partnerships,
corporations, and the like.
1.
Limitation in Chapter 7 Liquidations
Railroads, savings institutions, insurance companies, banks, and small business
investment companies may not file for bankruptcy under Chapter 7.
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2.
I CPA l.:xiHll Review
Compare Chapter 11 Reorganizations
a.
Anyone who can be a debtor (except a stockbroker or commodity broker) under
Chapter 7 may also be a debtor under Chapter 11. Additionally, railroads may be
a debtor under Chapter 11.
b.
Although Chapter 11 is intended primarily for business debtors, an individual is
eligible for relief under Chapter 11.
AN C ILL A R Y MAT E R I A L (for Independent Review)
3.
C.
Credit Counseling Required if Debtor is an Individual
a.
Counseling must occur no more than 180 days before filing the bankruptcy
petition.
b.
Pre-petition counseling may be waived if services could not be obtained within 5
days of requesting such services; however, in such a case the debtor must
receive counseling within 30 days after the petition is filed.
c.
Counseling also may be waived due to active combat duty, disability, or
incapacitation or it is determined that credit counseling agencies are not
reasonably available within the district.
d.
In addition, debtors filing under Chapter 7 or 13 must complete a financial
management course before their debts are discharged.
Duties of Debt Relief Agencies
The Bankruptcy Code imposes duties on debt relief agencies (i.e., agencies that are paid
compensation to assist consumer debtors in filing bankruptcy petitions). A debtor is
considered to be a consumer debtor if his debts are primarily consumer in nature and he has
less than $164,250 in nonexempt property.
1.
A debt relief agency must enter into a written contract with a debtor within five business
days after the first date on which the agency provides bankruptcy assistance and
before filing a petition. The contract must explain the services to be provided, fees and
charges, and payment terms.
2.
A debt relief agency may not advise a person to incur more debt in anticipation of a
bankruptcy filing.
3.
A debt relief agency that breaches the above duties may be subject to an action for
actual damages, costs, loss of fees, and/or an injunction.
END OF ANCILLARY MATERIAL
II.
COMMON FEATURES OF CHAPTER 7 AND CHAPTER 11 CASES
.1
A.
R7-20
Automatic Stay-Stops Collection Efforts
1.
When a bankruptcy petition is filed in either a voluntary case or an involuntary case, an
automatic stay becomes effective against most creditors.
2.
The stay stops almost all collection efforts (e.g., filing a law suit or simply demanding
payment).
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3.
B.
I CPA Exam Review
Regulation 7
The automatic stay does not apply to crimlnai prosecutions, paternity suits, and cases
brought to establish spousal or child support obligations.
Duties of Debtor
After a petition is filed, a debtor must file:
1.
A iist of creditors and their addresses;
2.
A schedule of assets and iiabilities;
3.
A schedule of current income and expenditures;
4.
A statement of the debtor's financial affairs;
5.
Copies of pay stubs received within 60 days before filing;
6.
An itemized statement of monthly net income;
7.
A disclosure of any reasonably anticipated increase in income or expenditures for the
twelve months after filing;
8.
Copies of federal tax returns from the iast tax year. If the debtor has not paid taxes for
the previous tax year, he or she must do so before the bankruptcy can proceed.
9.
A record of any interest that the debtor has in an education IRA or a qualified state
tuition program;
10.
If the debtor is an individual, a certificate from the nonprofit bUdget and credit
counseling agency that provided the debtor credit counseling services, along with any
plan of repayment developed by the agency; and
11.
If the debtor is an individual and has debts secured by property, a statement of her
intention with respect to the property (i.e., the debtor must specify whether she intends
to retain or surrender the property, claim it as exempt, redeem it, or reaffirm the debt).
Note: If an individual debtor in a voluntary Chapter 7 case fails to file any of the items
specified in 1-7, above, within 45 days after filing the petition, the case is automatically
dismissed on the 46th day.
C.
Chapter 7 and Chapter 11 May Be Voluntary or Involuntary
1.
Voluntary Cases
a.
Debtor Files for Order of Relief
A voluntary case under Chapter 7 or Chapter 11 is commenced by the debtor
filing a petition for relief.
b.
Debtor Need Not Be Insolvent - But Must Pass Income Tests
The debtor need not be insolvent to file. However, as previously discussed, a
Chapter 7 case may be dismissed if the debtor has too much income.
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c.
I CPA Exam Review
Spouses May File Jointly
Spouses may file jointly to avoid duplicative fees.
PASS KEY
While it may seem trivial. "spouses may file jointly" often appears as a correct answer on the
CPA examination.
d.
Voluntary Petition Constitutes an Automatic Order for Relief
A filed voluntary petition constitutes "an order for relief," which simply means a
case can proceed unless a court orders otherwise.
2.
Involuntary Case
Unsecured creditors may petition a debtor invoiuntarily into bankruptcy proceedings
under Chapter 7 or Chapter 11 .
a.
Grounds - Generally Not Paying Debts When Due
For an involuntary petition, creditors must show that the debtor generally is not
paying his or her debts as they become due.
b.
Ineligible Debtors - Farmers and Charities
Farmers and nonprofit charitable organizations may not be petitioned
involuntarily into bankruptcy.
c.
Who Must Join Petition - Owed At Least $14,425
Only creditors who are owed, individually or in aggregate, at least $14,425 in
unsecured, undisputed debt may petition a debtor involuntarily into bankruptcy.
The number of creditors who must file depends on the debtor's total number of
creditors.
(1)
Fewer Than 12 Creditors -1 or More Owed $14,425
If a debtor has fewer than 12 creditors, anyone or more creditors who are
owed at least $14,425 in unsecured debt may file.
EXAMPLE
Dee has four creditors she is not paying. Alex is owed $15,000, Bob is owed $4,000, Carla is
owed $4,000, and sam is owed $17,000, which loan is secured by Dee's $20,000 car. Alex must
join in an involuntary petition; Bob and Carla's claims are not sufficient. Sam may not file.
Sam's claim is adequately secured.
R7·22
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(2)
R0VievJ
Regulation 7
12 or More Creditors - 3 Owed $14,425
If a debtor has 12 or more creditors, at least three creditors who are owed
at least $14,425 in aggregate, in unsecured, undisputed debt must join in
the involuntary petition.
PASS KEY
The number of creditors and amounts owed necessary to file an involuntary petition is a
favorite exam issue. Two points should be noted:
•
•
d.
e.
Usually the examiners use this information to create "distracters" (Le., wrong answers),
such as "To file a voluntary petition, a debtor must owe at least $14A25" or "have at least
12 creditors." You should take time to memorize the $14A25 and one or three creditor
minimums. Remember, they apply only to involuntary petitions.
~
'
(
C
If a problem states the number of creditors that a debtor has, the examiners frequently
asked the number needed to file an involuntary petition. Spot in the questions statements
like "the debtor has 19 creditors" or "the debtor has 8 creditors."
An Involuntary Petition Does Not Constitute an Order for Relief
(1)
Unlike a voluntary petition, an involuntary petition does not constitute an
order for relief. There is a gap between the filing and the order of relief
called the involuntary case gap.
(2)
The court will enter an order for relief if the debtor does not object to the
petition within 20 days.
(3)
If the debtor does object, a hearing is held to determine the debtor's
solvency. The test for solvency is whether the debtor is generally paying
his debts as they become due.
(4)
Persons who become creditors of the debtor during the involuntary case
gap period are given high priority in recovering against the debtor's estate.
Dismissal of Petition - Damages
If creditors improperly filed an involuntary petition (e.g., insufficient number of
creditors, insufficient unsecured claims, debtor was paying debts as they became
due, etc.) a court may award the debtor compensatory damages, court costs,
attorney's fees, and even punitive damages if bad faith can be shown.
PASS KEY
Odd as it may seem, the Bankruptcy Code does not require a debtor to be insolvent to file for
bankruptcy. A voluntary petition may be filed by anyone who owes debts, and an involuntary
petition may be filed if the debtor is generally not paying debts as they become due,
regardless of the debtor's ability to pay. An answer choice that suggests that the debtor must
be insolvent to file for, or be petitioned into, bankruptcy is wrong, but be sure to remember
that an individual consumer debtor's Chapter 7 case may be dismissed or converted to Chapter
13 if his income is too high.
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'7-23
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~
Regulation 7
D.
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Section 341 Meeting-Creditors' Meeting
Ordinarily, within 20-40 days after the order for relief, a meeting of the creditors (called the
"Section 341 meeting") is held. All interested parties, inciuding creditors, the bankruptcy
trustee, and the debtor must be given notice of the meeting.
1.
Notice Requirements
The notice must include the name, address, and social security number of the debtor,
as well as notice of the automatic stay and final dates for filing claims.
2.
Debtor Must Attend
The debtor must attend the Section 341 meeting. The primary purpose of the meeting
is to provide creditors an opportunity to examine the debtor.
E.
•
Property of the Bankruptcy Estate
1.
2.
Property Included
a.
The debtor's estate (Le., assets available to payoff creditors) generally includes
all of the debtor's real and personal property at the time of filing.
b.
The estate aiso includes income generated from estate property (e.g., interest
from bonds that are part of the estate).
c.
It also includes property the debtor receives from divorce, inheritance, or
insurance within 180 days after the filing of the petition.
d.
Leases of property may be assumed and retained by the trustee, assumed and
assigned to another, or rejected by the trustee.
Property Excluded from Estate
a.
•
R7-24
Post-Petition Earnings, Spendthrift Trusts, EducationallRAs and State
Tuition Programs - Excluded From Debtor's Estate
Post-petition earnings of an individual debtor, spendthrift trusts, contributions to
educationallRAs and qualified state tuition programs made at least 365 days
before the petition was filed, and contributions by employees to qualified
employee benefit plans are excluded from the estate.
b.
Exempt Property-Generally Things Necessary to Live
(1)
An individual debtor is entitled to exempt certain property under the
Bankruptcy Code. The Code also allows states to adopt their own
exemptions. About two-thirds of the states have "opted-out" of the federal
exemption system in favor of their own, but the examiners have asked a
few questions regarding what property is exempt under federal
exemptions.
(2)
The exemptions most likely to appear are: (i) homestead (up to $21,625 of
residence property); (ii) motor vehicle (up to $3,450); (iii) household goods,
crops, and animals ($550 per item, up to $11,525 in total); (iv) unmatured
life insurance contracts; (v) tools of a trade or professional books (up to
$2,175); (Vi) health aids; (Vii) government benefits, such as social security,
veteran's benefits, unemployment compensation, and disability benefits;
and (viii) alimony, support, or maintenance (reasonably necessary for
support).
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3.
Regulation 7
Trustee's Powers as a Lien Creditor
a.
b.
Trustee is a Hypothetical Lien Creditor as of Filing Date
(1)
The trustee is treated as having a lien on all of the debtor's property the
instant the bankruptcy petition is filed.
(2)
This means that the trustee has priority over all creditors except creditors
with prior perfected security interests or prior statutory or judiciai iiens.
Caution-PM51 in Noninventory Collateral May Have Priority
The trustee will not prevail against PMSls in noninventory collateral that are
validly perfected under state iaw and within 30 days after the debtor receives
possession of the collateral. Recall, however, that in most states such perfection
is not valid under state law unless it occurs within 20 days after the debtor
receives possession of the collateral.
EXAMPLE
On July 1, Sue sells and delivers to Dan on credit certain equipment and properly reserves a
security interest in the equipment. On July 5, Dan files a petition in bankruptcy. On July 9, Sue
perfects her interest in the equipment by proper filing. Sue's PM 51 prevails over the
bankruptcy trustee's interest.
4.
Power over Fraudulent Transfer
•
a.
The trustee also has power to set aside fraudulent transfers made
within two years of the filing date.
b.
A fraudulent transfer is any transfer made with intent to hinder, delay, or defraud
creditors or any transfer where the debtor received less than equivalent value
while the debtor was insolvent. (See Creditors' Rights outline for more details.)
EXAMPLE
A few days before filing a voluntary petition in bankruptcy and while Debtor was insolvent, Debtor
gave Friend a $5,000 cash gift. The gift can be set aside (recovered from Friend) as a fraudulent
transfer.
5.
Trustee Can Disaffirm Preferences
The trustee has the power to set aside preferences. When the payment is "set aside,"
the payment is taken back from the creditor who received it and becomes part of the
bankruptcy estate.
a.
~
A Preferential Payment is:
•
(1)
A transfer made to or for the benefit of a creditor;
(2)
On account of an antecedent debt of the debtor;
(3)
Made Within 90 days prior to the filing of the petition (one year if the
creditor is an insider, such as an officer of the debtor organization or a
close relative of the debtor);
(4)
Made while the debtor was insolvent; and
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Regulation 7
Becker Professional Education I CPA Lxam Review
(5)
That results in the creditor receiving more than the creditor would have
received under the Bankruptcy Code.
PASS
KEY
Preferential payment is one of the most heavily tested issues when it comes to bankruptcy
questions on the CPA Exam, Be sure to memorize the definition above and the explanations
above, Understanding this material is one of the keys to your success!
b.
Purpose: Prevent One Creditor Being Preferred Over Others
The purpose of the preferential transfer rules is to prevent one creditor from
receiving an unfairly large repayment relative to other creditors. Improper intent
is not a requirement to classify a transfer as preferential.
EXAMPLE
A few days before Deanna, a retailer, filed her bankruptcy petition, she paid in full a two-year
unsecured installment loan owed to Carla, a creditor who had been very nice to Deanna.
Deanna's assets are such that other unsecured creditors will not be paid in full. The payment
to Carla can be set aside as a preference.
c.
Transfer
A transfer includes not only the payment of money or the giving of property, but
also the giving of a security interest.
EXAMPLE
Same facts as above, but instead of Deanna paying carla in full, Deanna gives Carla a security
interest in all of Deanna's inventory, which Carla perfects, Carla's interest can be set aside as a
preference.
d.
Antecedent (Preexisting) Debt
A payment is a preference only if it is for an antecedent (preexisting) debt. A
contemporaneous exchange for value is not a preference.
EXAMPLE
A few days before Deanna, a retailer, filed for bankruptcy, she received from Alex, a supplier,
six cases of goods to be put into Deanna's inventory. Deanna paid for the goods in full on their
arrival. There is no preference here; this is a contemporaneous exchange for value.
e.
Insolvency-Presumed During 90 Days Preceding Bankruptcy
The debtor is presumed to be insolvent during the 90 days immediately
preceding the date the bankruptcy petition is filed.
f.
Receipt of Greater Share-Creditor Received More
A preference exists only if the creditor receives more than he would receive in a
bankruptcy distribution. Therefore, payment to a fUlly secured creditor is not a
preference, because the creditor would have received the collateral and been
paid in full anyway.
R7-26
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g.
Regulation 7
Exceptions: Transfers that Cannot be Set Aside by Trustee
(1)
Transfers in the Ordinary Course of Business
A transfer made to repay a debt that the debtor incurred in the ordinary
course of business is not a voidable preference.
EXAM PlE
A regular monthly installment payment will not be set aside as a preference. Similarly,
payment of current utility bills or current lease payments do not constitute a
preference.
(2)
PMSI Perfected within 30 Days
A PMSI is not a voidabie preference if it is perfected within 30 days after
the debtor receives possession of the collateral, though it may be invalid
under state law if not perfected within 20 days of the debtor's receiving
possession.
(3)
Consumer Payments under $600
The trustee may not avoid payments or transfers of property of less than
$600 by a debtor whose debts are primarily consumer debts.
(4)
Domestic Support Obligations
Bona fide payments for domestic support obligations (e.g., spousal support
or child support) are not voidable preferences.
F.
Claims Against the Estate
Claims include all rights to payment from the debtor's estate.
1.
Unsecured Creditors and Equity Security Holders Must File
III
a.
To have a claim allowed (i.e., a right of payment against the debtor's
estate), unsecured creditors must file a proof of claim, and
shareholders must file a proof of interest with the bankruptcy court.
b.
Unless someone objects, a filed claim or interest will automatically be allowed by
the court. An unsecured creditor who fails to timely file a claim may not take part
in the distribution of the debtor's estate.
c.
Compare-Secured Claims
The general rule is that a perfected security interest passes through and survives
bankruptcy even if the creditor does not file a proof of claim.
G.
Miscellany
1.
The trustee can also serve as a professional (e.g., tax preparer, accountant or iawyer)
for the estate if the court approves.
2.
A trustee serving as tax preparer for the estate may receive compensation as a
professional in addition to the trustee's compensation, if a court approves.
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III.
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FEATURES OF A CHAPTER 7 LIQUIDATION
A.
Goal
The goal of federal bankruptcy law is to give an honest debtor a "fresh start" financially by
discharging most debts owed by the debtor.
B.
In General
In a liquidation, a bankruptcy trustee is appointed. The trustee collects all of the debtor's
nonexempt property, liquidates it, and pays off all of the debto~s creditors. Most debts of an
individual are discharged but certain debts survive bankruptcy.
C.
Objections to Discharge
Creditors often want to prevent debtors from receiving a Chapter 7 discharge. The Code
provides two kinds of ammunition for such claims: objections to discharge and
nondischargeable debts. The first type of ammunition destroys the entire Chapter 7 casenone of the debtor's debts will be discharged. The second type of ammunition prevents the
discharge of specific debts. The following will prevent the debtor from receiving any
discharge:
1.
Debtor Not an Individual
Technically, only individuais (i.e., real people as opposed to artificial entities, such as
corporations) can receive a discharge under Chapter 7. Artificial entities seeking relief
under Chapter 7 usually are dissolved at the conclusion of the case, and so their debts
are wiped out.
2.
Fraudulent Transfers or Concealment of Property
The debtor is not entitled to a discharge if she transferred, destroyed, or concealed
property in the year before or after the petition was filed with intent to hinder, delay, or
defraud creditors.
3.
Unjustifiably Failed to Keep Books and Records
The debtor is not entitled to a discharge if he unjustifiably concealed, falsified, or failed
to keep or preserve adequate books and records from which the debtor's financial
condition or business transactions might be ascertained.
4.
Prior Discharge within Eight Years
A debtor is entitled to only one discharge within an eight-year period. Eight years must
elapse before another discharge can be granted.
5.
Commission of a Bankruptcy Crime
In addition to constituting federal crimes, the following acts give rise to objections to
discharge when committed knowingly and fraUdulently in connection with the
bankruptcy case:
R7-28
a.
Making a false oath or account;
b.
Presenting or using a false claim;
c.
Giving or receiving a bribe; or
d.
Withholding records or documents.
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Regulation 7
Failure to Explain Loss of Assets
A debtor who is unable to explain satisfactorily the disappearance or loss of assets is
not entitled to a discharge.
7.
Refusal to Obey Orders or to Answer Questions
If the debtor refuses to obey a lawful order of the court, a discharge is denied.
8.
Improper Conduct in an Insider's Case
If during her own bankruptcy, or within one year prior to filing, the debtor commits one
of the above prohibited acts (fraudulent conveyance, false oath, etc.) in connection with
another case concerning an insider (relative, partner, etc.), the debtor may be denied a
discharge.
9.
Waiver
The debtor is not discharged from any debts if the court approves a written waiver of
discharge executed by the debtor after the order for liqUidation.
10.
Failure to Complete Financial Management Course
An individual debtor is not entitled to discharge if, after filing the petition, she fails to
complete the required instructional course on personal financial management.
PASS KEY
The examiners sometimes ask what will prevent a party from getting a discharge in bankruptcy. Historically
on the exam, the most often tested reasons are the first five, above.
The choice that historically has appeared most often is failure to keep records.
D.
I_I
Exceptions to Discharge
Certain debts of an indiVidual are not discharged under Chapter 7 or 11. Those
debts not discharged are called the "exceptions to discharge" and are as follows:
PASS KEY
It is important to remember that a bankruptcy case does not discharge all debts. The examiners often ask a
broad question such as, "Which of the follOWing is true under the Bankruptcy Code?" and one of the choices
often is that "all debts of the debtor are discharged." This is not true. The following debts survive
bankruptcy.
1.
Taxes Due Within Three Years of Filing
Most tax claims (federal, state or local) are nondischargeable if the return for the tax
was due within three years before the bankruptcy petition was filed.
2.
Debts Incurred by Fraud
Liabilities for obtaining money, property, or services by false representation or fraud are
not dischargeable.
3.
Luxury Goods
Consumer debts incurred for luxury goods (e.g., boat, jewelry, etc.) are not
dischargeable if the debts aggregate over $600 to a single creditor and are incurred
within 90 days of the order for relief.
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Open-Ended Credit to Consumers
Cash advances obtained by a consumer under an open-ended credit plan are
presumed to be nondischargeable if the debts are incurred within 70 days of the order
for relief and exceed the aggregate amount of $875. Thus, if a consumer makes
purchases on a credit card in an amount greater than $875 in the 70 days before
bankruptcy, the debt will survive bankruptcy.
5.
Debts Undisclosed in the Bankruptcy Petition
Any debt not scheduled or listed by the debtor in time to permit the creditor to file a
timely proof of claim is nondischargeable, unless the creditor had notice or actual
knowledge of the bankruptcy.
6.
Embezzlement, Larceny, and Fiduciary's Fraud
Liabilities arising from embezzlement or larceny are not dischargeable. Debts arising
from fraud by a fiduciary are also nondischargeable.
7.
Alimony, Maintenance, Support and Settlements from Marital Separation
Debts owed to the debtor's spouse, former spouse, or child (in or out of wedlock) for
alimony, maintenance, or support are nondischargeable, as are property settlements
arising out of a divorce decree or separation agreement.
8.
Willful and Malicious Injury
Liabilities arising from willful and malicious injury to another are not dischargeable.
However, liabilities arising from negligent torts are dischargeable.
9.
Operating a Vehicle While Intoxicated
Judgments rendered against the debtor for death or personal injury incurred as a result
of operating a motor vehicle, aircraft, or vessel while legally intoxicated survive the
debtor's discharge.
10.
Fines and Penalties
Any obligation to pay a fine, penalty, or forfeiture owed to a governmentai unit, such as
traffic fines, survives the debtor's discharge, as do court costs.
11.
Educational Loans
An education loan owed to a nonprofit institution of higher education or a student loan
that is made. guaranteed, insured, or funded by a government agency or commercial
entity is not dischargeable, unless it would impose an "undue hardship."
12.
Denial of Discharge in a Prior Bankruptcy
If a discharge was denied in a prior bankruptcy or a previous discharge was waived,
debts that predate the prior bankruptcy are not dischargeable in a subsequent case.
This exception does not apply if the basis for denial in the prior case was that the
debtor received a discharge within eight years.
13.
Debts Incurred to Pay Taxes
Debts incurred to pay taxes (e.g., where debtor uses credit cards to pay tax) are
nondischargeable.
14.
Debts Incurred Due to Violations of Securities Laws
Debts incurred due to violations of the securities laws are nondischargeable.
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Condo, Co-op, and Homeowners' Association Fees
Condominium, cooperative corporation, and homeowners' association fees that have
become due after the order for relief are not dischargeable if the debtor has an
ownership interest in the property.
16.
Restitution for Federal Crimes
Orders to pay restitution for federal crimes are nondischargeable debts.
17.
Prisoner's Court Fees
Fees imposed on a prisoner by a court for filing a legal pieading are nondischargeable.
18.
Fines for Federal Election Law Violation
A fine or penalty imposed under a federal eiection law is not dischargeable.
19.
Debt Owed to Pension or Profit-Sharing Plan
An obligation to repay a loan to a pension, profit-sharing, or stock bonus plan is not
dischargeable.
PASS
KEY
The examiners often ask what debts will not be discharged by a bankruptcy. The key to remembering the six
nondischargeable debts that most commonly appear on the exam is the word "WAFTEDlI : Willful and
malicious injury, Alimony, Fraud, Taxes, Educational loans and Debts undisclosed in the bankruptcy petition.
E.
Reaffirmation of Discharged Debts
Sometimes a debtor does not want a particular debt discharged in bankruptcy (e.g., to
maintain good relations with a particular creditor). The debtor may reaffirm such debts only if
the following requirements are met.
F.
1.
The agreement to reaffirm the debt was made before the granting of the discharge.
2.
The agreement contains a clear and conspicuous provision that the debtor has a right
to rescind the agreement any time prior to discharge or within 60 days after the
agreement is filed by giving notice to the creditor.
3.
Upon a discharge, the debtor's attorney or the court (if the debtor is not represented by
counsel) informs the debtor that reaffirmation is not required by law and advises the
debtor of the legal effect of reaffirmation.
Revocation of Discharge
A creditor or trustee may request the discharge be revoked for the following:
1.
The debtor obtained the discharge fraudulently and the party seeking revocation did not
discover the fraud until after the discharge was granted;
2.
The debtor acquired property that would constitute property of the estate and knowingly
and fraudulently failed to disclose this fact; or
3.
The debtor failed to obey a court order or answer material questions; or
4.
The debtor has not given a satisfactory explanation for a failure to make documents
available in connection with an audit that may be ordered by the United States Trustee
or for a material misstatement in such documents.
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Distribution of the Debtor's Estate-Payment and Priorities
Once the debtor's assets have been collected and liquidated, and all objections have been
disposed of, the trustee will distribute the assets of the estate. There are three basic
categories of claimants, which are paid in the following order.
(i)
Secured claimants;
(ii)
Priority claimants (which itself includes nine sUbcategories); and
(iii)
General creditors who filed their claims on time.
Payments are made in full to secured claimants to the extent of the value of the collateral
securing their claims (claims in excess of the collateral are treated like claims of other general
creditors). Whatever is left over then is used to pay first priority claimants in full, then second
priority claimants in full, then third priority claimants are paid, and so on. If money is left after
paying all of the priority claimants, it is then split among the general creditors who filed their
claims on time. If there is not sufficient money to pay all creditors at a particular level, the
creditors share pro rata.
PASS KEY
The priority rules are, perhaps, the most heavily tested rules on the CPA Exam when it comes to bankruptcy
issues. Your memorization of the order of payment and the dollar limitations specified below is key for
success on the exam.
1.
First Priority: Support Obligations to Spouse and Children
First priority goes to claims for domestic support obligations that are owed to a spouse,
former spouse, or child of the debtor on the date the petition is filed. But note: If a
trustee has been appointed or elected, the trustee has superpriority over claims for
domestic support obligations for administrative expenses to the extent such expenses
were incurred in administrating assets that benefit the support claim.
2.
Second Priority: Administrative Expenses
The expenses of a bankruptcy administration receive second priority. Bankruptcy
administration expenses include costs of preserving the estate, trustee fees, filing fees,
attorney and accountant fees, etc.
3.
Third Priority: Involuntary Case Gap Claims
Claims that accrue in the ordinary course of business after an involuntary petition is
filed, but before the order for relief or appointment of a trustee, receive a third priority.
4.
Fourth Priority: Wage Claims up to $11,725
Employees who have claims for wages earned within 180 days prior to the filing of the
petition receive a fourth priority. However, this priority is limited to $11,725 per
employee. For example, if an employee is owed $15,000 for wages, $12,000 of which
was earned within 180 days prior to bankruptcy, the employee would have an $11,725
priority claim and a $3,275 non priority claim.
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Regulation 7
.
EXAMPLE
Rivers has been involuntarily petitioned into bankruptcy. The following are claims and expenses against Rivers' estate:
Claims and Expenses
Fees earned by bankruptcy trustee
$15,000
5,000
10,000
Claims by secured creditors
Fees earned by attorneys for bankruptcy estate
Claims by Rivers' employees for wages earned within
180 days of the filing of the bankruptcy petition
2,000
What amount will be distributed by the trustee if cash available for distribution is $1S,000?
Total cash available for distribution
less: Secured claims
Cash available for priority claimants
$15,000
-5,000
llQ,QQQ
Since total administrative expenses ($1S,000 trustee fee plus $10,000 attorneys' fee =
$25,000) exceed cash available ($10,000), the cash available is prorated between the
administrative claimants. Since wage claims are a lower category, the employees would
receive nothing. The trustee's distribution is calculated as follows:
Trustee's
Distribution
Trustee's claim
Total administrative expense
$15,000
$25,000
-
3
5
x
Remaining cash available
x $10000
'
x $10,000
$6,000
5.
Fifth Priority: Employee Benefit Plans up to $11,725
Claims for contributions to employee benefit plans (e.g., health insurance or pension
plans) receive a fifth-level priority if they arose within 180 days prior to bankruptcy.
This priority may not exceed $11,725 per employee and is reduced by the amount paid
to each employee as a fourth priority wage claim.
PASS
fl~m:~mber that there
KEY
are 3 restrictions on priority payments for unpaid wages and unpaid employee
benefit plans:
•
Itis only unpaid wages and unpaid employee benefit plans that arose within 180 days prior to-the
-filing that,are entitled to a priority. Those that arose after filing are nonpriority c1alms~
•
It is only unpaid wages and unpaid employee benefit plans up to $11,725 that receive a priority.
The $11,725 priority for unpaid employee benefits is reduced by any amount paid to the employee for
a priority wage claim.
6.
Sixth Priority: Grain Farmers and Fishermen up to $5,775
Claims of grain producers or United States fishermen against a debtor who operates a
grain storage facility or a fish produce storage or processing facility have a sixth priority
up to $5,775.
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Seventh Priority: Consumer Deposits up to $2,600
Consumer claims for a deposit made to a retail business prior to the retailer's
bankruptcy are entitled to a seventh-level priority to the extent of $2,600 for each
consumer. For example, if a consumer made a $3,000 deposit for furniture to be
delivered, but the seller files a bankruptcy petition prior to delivery, the consumer is
entitled to a $2,600 seventh priority and a $400 non priority claim.
8.
Eighth Priority: Tax Claims
Most tax claims are entitled to an eighth-level priority.
9.
Ninth Priority: Personal Injury Claims Arising from Intoxicated Driving
Claims for death or personal injury arising from the operation of a motor vehicle or
vessel by the debtor while he was legally intoxicated have a ninth priority.
PASS
KEY
The examiners frequently ask questions requiring candidates to prioritize debts. Remember properly p~rfected
secured creditors are paid up to the value of their collateral. They are unsecured, non-priority creditors for any
deficiency. The order of payment for the nine priority creditors can be learned by the mnemonic SAG WEG M
eTl.
S
=
A
= Administrative expenses of bankruptcy proceeding
G
=
Gap creditors
W
=
Wages up to $11,725 for each employee if earned within 180 days prior to filing
E
=
Employee benefit plan contributions up to $11,725 for each employee, reduced by wage claims,
if earned within 180 days prior to filing
G
= Grain farmers' and fishermen's claims up to $5,775
C
= Consumer deposits for goods paid for but not delivered up to $2,600
T
= Taxes
=
10.
Support obligations to spouse and children
Injury claims caused by Intoxicated driving
Non-Priority Claims
Any money that is left over after paying the secured creditors and the priority claimants
is used to pay the general unsecured creditors who timely filed, pro rata. If any assets
are remaining after paying general creditors who timely filed, creditors who filed late
receive payment.
R7-34
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Regulation 7
EXAMPLE
On June 1, Riviera was involuntarily petitioned into bankruptcy. On June 30, a trustee in bankruptcy was appointed and an
order for relief was entered. The claims and expenses against Riviera's estate are presented below.
Claims and Expenses
Fees earned by bankruptcy trustee
Fees earned by attorney for bankruptcy estate
Claims by secured creditors
Claims by Riviera's employees for wages earned within
180 days of the filing of the bankruptcy petition
Claims by Evakcia Corp. (One of Riviera's suppliers)
for camera equipment ordered on June 3, and delivered on June 28
Claims by unsecured general creditors
$15,000
10,000
5,000
2,000
20,000
1,000
What amount will be distributed to Evakcia Corp. if cash available for distribution is
$41,0007
Total cash available
less: Claims by secured creditors
Amount available for priority claimants
less: Administrative expenses
Bankruptcy trustee
Attorneys for bankruptcy estate
Amount available for involuntary gap claims
$41,000
-5,000
36,000
15,000
10,000
25,000
$11 000
Although Evakcia Corp. has a claim for $20,000, it will only receive $11,000.
PASS
KEY
It is important to understand the relationship between the exceptions to discharge and payment priorities. Some items are
both apriority and an exception; other items are one, but not the other. Payment is made accoreting to the priority rules
(without regard to whether the debt is excepted to discharge). After all possible payments have been made; any remaining
debts are discharged unless they are one of the exceptions to discharge. In some cases a debt that is an exception to
discharge will have been paid in the distribution process. For example:
•
If creditors are paid in full through the eighth priority (tax claims, etc.), then the fact that a tax claim is an exception to
discharge is irrelevant because it has been paid.
•
If, on the other hand, payment is made only through the sixth priority, then any unpaid seventh priority (consumer
deposits) claims are discharged (because they are not on the exception list), Any unpaid eighth priority (tax) claims are
not discharged because they are an exception to discharge.
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FEATURES OF REORGANIZATION CASES UNDER CHAPTER 11
A.
B.
Creation of Creditors' Committee
1.
In a Chapter 11 case, shortly after the order for relief is effective, a committee of
unsecured creditors is appointed, usually consisting of willing persons holding the
seven largest unsecured claims against the debtor.
2.
A person engaged in business other than real estate with debts not exceeding about
$2.3 million can elect to be treated as a small business. Such a debtor can request that
a creditors' committee not be appointed.
Creation of Equity Security Holders' Committee
If the debtor is a corporation, an equity security holders' (Le., stockholders) committee may be
appointed consisting of the seven largest hoiders of the equity securities to ensure the equity
security holders receive adequate representation.
C.
Powers of Committees
The committees can consult with the debtor, investigate the debtor's finances, participate in
preparing the reorganization plan, etc.
D.
Debtor Generally Remains In Possession
1.
In Chapter 7 liquidations a trustee is appointed to take over a debtor's assets.
2.
In a Chapter 11 reorganization case, committees are appointed to consult with and
advise the debtor, but a trustee generally is not appointed.
a.
Instead the debtor remains in possession of the debtor's assets because the
debtor is presumed to be in the best position to run the business.
PASS KEY
The examiners like to ask about the trustee in a Chapter 11 case. Remember the general rule
that a trustee usually is not appointed in a Chapter 11 case; the debtor usually remains in
possession of the estate's assets.
b.
E.
A trustee can be appointed in a Chapter 11 case on a showing of fraud,
dishonesty, incompetence, or gross mismanagement on the part of the debtor's
estate. In such cases, a trustee may run the debtor's business.
Chapter 11 Reorganization Plan
The debtor may file a reorganization plan under Chapter 11 any time during the bankruptcy
case. Unless a trustee has been appointed, the debtor has an exclusive right to file a plan
during the first 120 days after the order for relief is effective. Other interested parties (e.g.,
creditors) may file a plan if:
R7-36
(i)
A trustee has been appointed;
(Ii)
The debtor has not filed a plan within 120 days after the order for relief; or
(iii)
The debtor has filed a plan but has not obtained the acceptance of every impaired
class (e.g., creditors whose claims are reduced by the plan or will be paid later than
contracted for) within 180 days after entry of the order for relief.
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Contents of the Plan
A Chapter 11 plan must, among other things:
2.
3.
a.
Classify all claims (e.g., secured, first priority, second priority, impaired,
unimpaired, etc.);
b.
Describe the treatment to be accorded each impaired class;
c.
Treat each claimant Within a particular class identically; and
d.
Establish ways to implement the plan.
Acceptance of the Plan by Creditors
a.
Any creditor or equity security holder who has fiied a claim against the debtor's
estate must be given an opportunity to accept or reject the pian.
b.
A class of impaired claims is deemed accepted if it is accepted by creditors
holding at least two-thirds in amount and more than one-half in number of the
allowed claims.
c.
A class of impaired interests (e.g., equity security holders) is deemed to have
accepted the plan if it is accepted by equity security holders having at least twothirds in amount of the allowed claims.
Confirmation of the Plan by Court
a.
b.
The court wili confirm the plan if:
(1)
It is accepted by all impaired classes;
(2)
It provides for payment of all second priority administrative expenses and
all third priority involuntary gap creditors in cash;
(3)
It provides for payment in full in cash of third, fourth, fifth, sixth, and
seventh priority claims unless the class has accepted the plan;
(4)
It provides for regular cash installment payments of eighth priority tax
claims of a vaiue equal to the allowed amount of the claim;
(5)
It provides for payment in full of all domestic support obligations that first
became payable after filing the petition;
(6)
When the debtor is an individual and an unsecured creditor objects to
confirmation, it provides that the value of the property to be distributed
equals the amount of the claim, or at least equals the debtor's projected
disposable income for the greater of five years from the date of the first
payment or the period for which the plan provides payment; and
(7)
The plan is feasible (i.e., has a reasonable probability of succeeding).
Cram Down: A plan can be confirmed by the court even if it is not accepted by all
impaired classes if:
!GI",..l.fl/,l!
(1)
At least one impaired class has accepted; and
(2)
The court finds that the plan is not unfairly discriminatory and is fair and
equitable with respect to any dissenting impaired classes.
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F.
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Effects of Confirmation
1.
A confirmed Chapter 11 plan is binding on all creditors, equity security holders, and the
debtor regardless of whether they accepted the plan.
2.
Generaliy, once confirmed the debtor pays debts according to the plan.
3.
Unless the order provides otherwise, confirmation discharges the debtor from all preconfirmation debts (except that debts not discharged under Chapter 7 are also not
discharged under Chapter 11).
4.
Confirmation also terminates the automatic stay.
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Regulation 7
SECURITIES REGULATION
I.
INTRODUCTION
A.
Securities Act of 1933 and Securities Exchange Act of 1934
The two major securities acts that you must know are the Securities Act of 1933 and the
Securities Exchange Act of 1934. The 1933 Act regulates original issuances of securities,
while the 1934 Act regulates purchases and sales after initiai issuance.
B.
II.
Security Defined-Any Investment Contract
1.
Courts have defined the term security very broadly.
2.
A good rule of thumb for determining whether something is a security is to ask whether
the investor expects to take part in the management of the business. If the investor is
passive-i.e., relies solely on the management of others to make money-the
investment most likely is a security.
3.
Stocks, bonds, debentures, oil well interests, stock options, collateral trust certificates,
warrants, and limited partnership interests are deemed securities and investment
contracts.
4.
Certificates of deposit and general partnership interests are generaiiy not deemed to be
securities. In the case of general partners, each partner is expected to participate in
running the business.
THE SECURITIES ACT OF 1933
A.
Introduction
1.
Purpose-Provide Investors with Sufficient Investment Information
a.
The goai of the Securities Act of 1933 is to assure that investors have sufficient
information on which to make an informed investment decision.
b.
It accompiishes this goal by requiring most issuers to register new issues of
securities with the Securities Exchange Commission (SEC) (unless an exemption
applies) and provide prospectuses containing material information regarding the
securities to prospective investors.
c.
The SEC does not guarantee the accuracy of this information, evaluate the
offering's financial merits, or give assurances against loss.
PASS
KEY
~:~:~~:~:h~~;~~O;:CO~O~:nC;~::~;'itnh~i~;c~~:~ya::;::i~~~:~~;i~~~~~eo~fe~a~ul~:3t~:fina~cl~I',
meritsofthe secu-rities being offered. It merely assures the presence of information necessary for
investors to make informed decisions.
2.
Those Required to Register-Issuers, Underwriters, and Dealers
The registration requirements of the 1933 Act only apply to issuers, underwriters, and
dealers.
a.
An issuer is the entity whose securities are being sold.
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b.
An underwriter is an intermediary who sells an issuer's securities to the general
pUblic or to dealers.
c.
A dealer is one who sells or trades securities on a full- or part-time basis.
The Registration Statement
Most securities cannot be sold unless they are first registered with the SEC. The registration
statement consists of two parts. Part I is the prospectus. Part II contains detaiied information
regarding the securities to be issued.
Part I: The Prospectus-A Written Offer to Sell Securities
2.
a.
In broad terms, the 1933 Act defines "prospectus" as any written, radio, or
television offer to sell securities.
b.
The prospectus in Part I of the registration statement (called a "statutory
prospectus") summarizes important information contained in Part II.
c.
Unless an issuance is exempt, each investor must receive a copy of the
prospectus before or contemporaneous with every sale of the security.
Part II: Information About the Securities Being Issued Must Include:
a.
b.
Audited Balance Sheet and Profit and Loss Statement
(1)
The registration statement must include a balance sheet dated not more
than 90 days before the filing, and a profit and loss statement of the
issuer's net income or loss for the preceding five years.
(2)
The financial statements must be certified by a public accounting firm
registered with the Public Company Accounting Oversight Board.
Other Material Facts Requiring Disclosure
The registration statement must also include a description of the issuer's
business and the following (if available):
3.
I-I
4.
(1)
The names and addresses of the directors, officers, underwriters, and
shareholders who own 10% or more of the company's shares.
(2)
The amount of stock and debt the issuer has outstanding.
(3)
The principal purposes for which the offering proceeds will be used.
(4)
Anything that might affect the value of the securities being issued (e.g.,
absence of an earnings history, pending litigation, etc.).
Shelf Registrations-Registration Statement for Future Issuances
a.
Many issuers are aimost constantly involved in issuing new securities. It would
be helpful if they could prepare just one registration statement for all securities
that they will offer in the future (so-called shelf registration).
b.
Although generally prohibited, shelf registration is permitted if the issuer has
continuously filed under the 1934 Act for one year (i.e., not a first-time issuer)
and the information is continuously updated.
Processing the Statement
The SEC reviews the registration statement to ensure both parts are complete.
• 7-40
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Effective Twenty Days after Filing
The registration statement becomes effective on the twentieth day after its filing with
the SEC unless the SEC issues a refusal or stop order.
6.
Blue Sky Laws-State Laws Governing Stock Sales
Slate laws governing stock sales are known as "blue sky" laws. However,
much of state blue sky law has been preempted by federal law.
C.
II
Timetable of Sales Activity
1.
Thirty Days Before Registration (Prefiling Period )-No Sales Activity Allowed
Generally no sales activity is allowed within the 30 days before registration, unless the
issuance is exempt. However, an issuer is permitted to negotiate with an underwriter.
Communications made more than 30 days before a registration generally do not
constitute sales activity.
2.
After Registration but Before Effectiveness (Waiting Period)
There is a 20-day waiting period between registration and the filing date. Sales are
generally prohibited during this period, but some sales activities are allowed:
3.
a.
Oral offers to sell (but no written offers to sell) can be made;
b.
Tombstone ads can be made (ad identifies the security, its price and
who will execute orders).
c.
Preliminary (red herring) prospectus can be made (similar to the
statutory prospectus, but contains a statement in red ink that it is not
yet final).
d.
Summary prospectuses are allowed (but these are outmoded and seidom used).
1"\
l'iM".'1
After Effective Date (Post-Effective Period)
After the registration is effective (20 days after filing or as the SEC directs), the
securities may be sold. All investors must receive a prospectus before or with the sale.
~--------_.,O
AN C III A R V MAT E R, A l (for Independent ReView)
4.
Special Rules for Some 1934 Act Reporting Companies
There are special rules for seasoned issuers and well known seasoned issuers
("WKSls"-pronounced wick-sees).
a.
Seasoned issuers are issuers that have been continuously reporting under the
1934 Act for at ieast 12 months, have not failed to pay a dividend or required
payment on preferred stock, and have not defaulted on material debt or a longterm rent obligation in the current fiscal year.
b.
Well known seasoned issuers are seasoned issuers with at least $700 million in
equity outstanding worldwide in the hands of persons not affiliated with the issuer
or most issuers that have issued at least $1 billion in nonconvertible securities in
the last three years.
c.
Seasoned issuers may release factual business information, including ads for its
products, during the waiting period, but the information cannot contain anything
about the registered offering.
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d.
A WKSI may make oral or written offers, at any time. WKSls also have a special
form of shelf registration that is effective immediately.
e.
WKSls and seasoned issuers may also issue a "free writing" prospectus.
Such a prospectus must include a iegend that a registration statement has been
filed and advising how a reader can obtain a preliminary prospectus and may
contain anything else that does not conflict with the registration statement.
f.
Copies of a free writing prospectus must be filed with the SEC before first use
and must be retained for three years.
END OF ANCILLARY MATERIAL
D.
Exemptions from Registration
Not every sale of securities is covered by the 1933 Act. The Act has two types of
exemptions: securities exemptions (securities issued by certain types of issuers) and
transaction exemptions (securities issued in certain types of transactions).
1.
Securities Exemptions
Section 3 of the 1933 Act specifically exempts the following securities from the
registration requirements; the following securities never have to be registered:
a.
Securities issued by banks and savings and loans (e.g., CDs);
b.
Securities issued by not-far-profit organizations;
c.
Securities issued by the government (except for certain securities issued for
proprietary rather than governmental purposes);
d.
Securities of regulated common carriers (e.g., securities issued by railroads);
e.
Short-term commercial paper (notes, bonds, etc.) with a maturity date of nine
months or less;
f.
Insurance policies (but stocks, bonds, and similar securities of insurance
companies are not exempt);
g.
Securities issued under Chapter 11 of the Bankruptcy Code; and
h.
Securities issued by a church plan or similar entity that is not an investment
company.
PASS KEY
the-examiners often ask about exemptions from the registration requirements of the 1933 Act.
Remember that all issues of securities must be registered unless the securities are exempt. Favorite
securities exemptions on the exam appear to be securities of charitable organizations and bonds
issued by municipalities for governmental purposes.
2.
Transaction Exemptions
Transaction exemptions depend on the nature of the offering. Unlike the securities
exemptions, which exempt a security forever, the transaction exemptions exist only for
the transaction in question. If the securities are resold, they must be registered unless
they qualify for another exemption.
R7-42
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Regulation 7
Casual Sales Exempt-Not an Issuer, Underwriter or Dealer
Registration requirements apply only to issuers, undelWriters, and dealers.
Sales by others are considered casual sales and are exempt.
EXAM PtE
Dee, a practicing CPA, owns 10,000 shares of General Motors stock and decides to sell them. She need
not register. This is a casual sale. Dee is not the issuer, an underwriter or a dealer.
b.
c.
d.
e.
Exchanges with Existing Holders; Corporate Reorganizations
(1)
The 1933 Act provides an exemption when an issuer exchanges securities
with its existing holders provided no commission is paid (e.g., stock
dividends and stock splits).
(2)
There is also an exemption for government-approved exchanges that
occur as a result of corporate reorganization.
Intrastate Sales
(1)
Section 3(a)(11) of the 1933 Act provides an exemption for securities
offered and sold only to persons who are residents of the issuer's state
(i.e., the state where it is doing business).
(2)
Under rule 147, which implements Section 3(a)(11), the entire issue must
be offered and sold only to residents of that state, the issuer must do at
least 80% of its business in that state, and purchasers cannot resell the
securities for nine months.
Regulation A (Partial Exemption)
'QMI.lW'l
(1)
Regulation A is a partial exemption, permitting a simplified form of
registration that costs less to prepare than full registration.
(2)
Under RegUlation A, instead of fiiing a registration statement, the issuer
files an offering statement, which consists of a notification and an offering
circular.
(3)
RegUlation A sales may not exceed $5 million in a 12-month period.
Private Offering Exemption-Regulation 0
liMNd·hi"1
Regulation D exempts "private" offerings, and the SEC has three private offering
exemptions under Regulation D: ruies 504, 505, and 506. The exemptions share
certain general conditions, but each also has specific conditions.
f.
General Conditions that Apply to Rules 504, 505, and 506
(1)
General Solicitation Usually Prohibited-No Advertising
Regulation D is intended for private offerings. Thus, the reguiation
prohibits general advertising of the securities.
(2)
Immediate Resale to Public Prohibited
The purchasers may not immediately reoffer securities issued under
Regulation D to the public. The issuer must insure that purchasers wiil
hold for long-term investment (two years or more), not resale. Before two
years is up, such securities are "restricted," and the buyer cannot reseil
them unless the resale fails under Regulation D or another exemption.
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SEC Must be Informed within 15 Days
The SEC must be notified of the issuance of securities under Regulation D
within 15 days after the first sale.
g.
1';MiNil
h.
•
Requirements of Rule 504-$1 Million Limit
(1)
To be exempt under ruie 504 the issuance of securities may not exceed $1
million within a 12-month period.
(2)
Rule 504 has no limitation on the number or type of purchasers.
(3)
Rule 504 generally does not require any specific disclosure to investors
prior to the sale.
Requirements of Rule 505-$5 Million Limit
(1)
To be exempt under rule 505 the issuance of securities may not exceed $5
million within a 12-month period.
(2)
Securities issued under ruie 505 may be sold to any number of accredited
investors and 35 or fewer unaccredited investors. Note that an accredited
investor is one such as an institutional investor, a bank, a natural person
with at least $1 million in net worth or $200,000 in annual income, officers
or directors of the issuer, etc.
PASS KEY
The examiners often try to trick you with the 35 unaccredited investor limit. Watch for fact
patterns that state that Regulation Dofferings cannot be made to more than 35 investors.
Such a choice is incorrect because generally there is no limit on the number of unaccredited
investors under rule 504. Moreover, the 35 investor limit under rules 505 and 506 (below)
applies only to unaccredited investors-there can be any number of accredited investors. Note
also that the limitation goes to the number of actual purchasers and not to the number of
offerees.
(3)
1';ffi"iU,1
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i.
If only accredited investors purchase, no disclosure is required. If there
are any unaccredited investors, all investors must be given at least an
annual report containing audited financial statements.
Requirements of Rule 506-Unlimited Dollar Amount
(1)
Under rule 506 there is no limit on the amount (dollar value) of stock that
may be sold.
(2)
Securities issued under rule 506 may be sold to any number of accredited
investors and 35 or fewer unaccredited but sophisticated investors (Le., the
issuer must reasonably believe the unaccredited investor has sufficient
knowledge and experience in financial matters to be capable of evaluating
the risks of the investment).
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(3)
Regulation 7
If only accredited investors purchase, no disclosure is required. If there
are any unaccredited investors, a/l investors must be given at least an
annual report containing audited financiai statements.
PASS KEY
The examiners ask very picky questions concerning rule 504, 505, and 506 offerings under
Regulation.O. You should memorize the information given above, especially the information
concerning limitations on amounts and investors. Also remember that general solicitation
generally is prohibited under rules 504, 505, and 506.
Rule 504
Rule 505
Rule 506
Is general advertising allowed?
Generally no
No
No
Notice required to SEC?
15 days
15 days
15 days
Reoffers to public prohibited?
Yes
Ves
Ves
Dollar limitation
$1 million
$5 million
None
Limits on unaccredited buyers?
No limit
Up to 35
Up to 35 who
must be
sophisticated
Limits on accredited buyers?
E.
No limit
No limit
Liability under the 1933 Act
1.
In General: Liability Under Section 11, 12 and 17
a.
Section 11 imposes civil liability for misstatements, whether or not intentional, in
registration statements.
b.
Section 12: Civil Antifraud Section of the 1933 Act
c.
~2010
No limit
(1)
Section 12 imposes civil liability if a required registration was not made; if a
prospectus was not given to ali investors or if materially false statements
were made or omitted in connection with sales or offers to seil.
(2)
The immediate purchaser may sue for damages. The purchaser need not
prove scienter or reliance.
Section 17: Criminal Antifraud Section of the 1933 Act
(1)
Section 17 imposes criminal penalties against anyone who uses any type
of fraud in connection with the issuance of a security.
(2)
Section 17 is enforced by the SEC and prosecuted by the Justice
Department.
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Review
Section 11 Liability
Examiners have focused their attention on the provisions of Section 11.
a.
Elements of a Section 11 Cause of Action
Section 11 makes anyone who signs a registration statement liable for all
damages caused by any misstatement of material fact in the registration
statement. A person wishing to sue under Section 11 need only show:
(1)
The plaintiff acquired the stock (need not be the initial purchaser).
(2)
The plaintiff suffered a loss (i.e., suffered damages).
(3)
The registration statement contained a material misrepresentation or
material omission of fact.
The cause of action must be brought within one year after discovery and within
three years from the offering date. Note also that the plaintiff need not prove an
intent to deceive or negligence or reliance on the part of the defendant. Finally,
note that damages are the only remedy-rescission is not available.
PASS
KEY
Section 11 is a very heavily tested issue. The key is to remember that the plaintiff need only prove:
she acquired the stock, suffered a loss, and a material misstatement or material omission of fact. The
plaintiff need not prove any type of intent (scienter) or negligence. Neither need the plaintiff prove
reliance on the false statement.
b.
Who May be Liable?
Anyone who signs a registration statement may be liable under Section 11.
Independent CPAs audit the financial statements in a registration statement and
attest to their accuracy. Thus, the signing CPA is liable for material
misstatements in the registration statement that result in loss.
EXAM PlE
While conducting an audit, Annie, CPA, failed to detect material misstatements included in the
client's financial statements. Annie's unqualified opinion was included in the financial
statements in the registration statement for a public offering of securities. Annie knew that
the financial statements would be used for this purpose. Penny purchases the securities and
incurs damages. Penny can sue Annie for damages.
•
.......
c.
",
d.
Due Diligence Defenses
(1)
Defendants, other than issuers, are not liable if they can prove they used
due diligence (called the due diligence defense).
(2)
Due diligence means that the defendant had reasonable grounds to
believe the facts in the registration statement were true and no material
facts were omitted.
Misstatement Did Not Cause Plaintiff's Damages
(1)
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It also is a defense to liability under Section 11 if the defendant can prove
that the misstatement did not cause the plaintiff's damages.
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Regulation 7
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(2)
III.
This includes cases when the misstatement was not material or when the
plaintiff knew of the untruth or omission in the statement at the time she
purchased her securities.
THE SECURITIES EXCHANGE ACT OF 1934
A.
B.
Introduction
1.
While the Securities Act of 1933 is concerned with the initial issuance of securities, the
1934 Securities Exchange Act is concerned with exchanges (e.g., sales, purchases,
etc.) of securities after they are issued.
2.
The 1934 Act has registration and reporting provisions that appiy only to certain
companies and anti-fraud provisions that apply to ali purchasers and sellers, regardless
of registration.
3.
The SEC can seek suspension or revocation of a company's registered securities for
violation of the 1934 Act's registration or reporting requirements.
Registration Requirements
The 1934 Act requires certain, Widely traded, companies to register with the SEC.
1.
1934 Act Registration Requirements
a.
b.
2.
3.
Only two types of companies must register their securities.
(1)
Companies whose shares are traded on a national exchange; and
(2)
Companies that have at ieast 500 shareholders in any outstanding class
and more than $10 million in assets.
National stock exchanges, brokers and dealers must also register.
Information Required in Registration Statement
a.
The registration statement must include the company's financial structure; nature
of its business and outstanding securities; the names and remuneration of
directors, officers, underwriters, and 10% or more shareholders; outstanding
options; and material contracts.
b.
The registration statement must also include financial statements audited by a
pUblic accounting firm reg istered with the Public Company Accounting Oversight
Board.
Exemptions
Securities of investment companies, savings and loans, and charitable organizations
are exempt.
PASS KEY
Examiners frequently ask about reporting companies; those companies required to register under the 1934
Act. Remember registration is required if the shares are sold on a national exchange. Registration is equally
required if the company has 500 or more shareholders and more than $10 million in assets.
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R7-47
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1934 Act Reporting Requirements
1.
Companies Required to Report-Called Reporting Companies
There are two categories of companies required to make reports. These companies
are referred to as "reporting companies."
2.
a.
All companies required to register under the 1934 Act must report (I.e., those
sold on a national exchange or those with 500 or more shareholders and more
than $10 million in assets).
b.
Any issuer that must register under the 1933 Act must also report.
Periodic Business Reports-10K, 10Q, and 8K
Companies registered under the 1933 Act or the 1934 Act are required to file the
following periodic reports:
l'i'liUiN,'1
3.
•
4.
5.
a.
Form 10K (Form 10-KSB for small businesses) is a required report that must be
filed annually within 60 days (for large corporations-90 days for small
businesses) of the end of the fiscal year. It must contain material facts
concerning management or otherwise impacting the value of the company's
securities and financial statements certified by independent accountants.
b.
Form 100 (Form 10-0SB for small businesses) is a quarterly report filed within
40 days (for large corporations--45 days for small ones) of the end of the first
three quarters of each fiscal year. It must contain reviews of interim financial
information by independent CPAs.
c.
Form 8K must be filed within 4 days after a major change in the company, such
as a change in controi, disposition of major assets, change in officers or
directors, resignation of directors, etc.
5% or More Owners Must Report-To SEC, Issuer, and Exchange
a.
Any person acquiring 5% or more beneficial ownership in any equity security
registered under the 1934 Act must file a report with the SEC, the issuer and the
exchange on which the security is traded.
b.
The report must include background information about the purchaser, the source
of her funds and her purpose in buying .
Tender Offers Must be Reported-By the One Making the Tender Offer
a.
A tender offer is an offer to all shareholders to purchase stock for a specific price
for a specified period of time.
b.
Any party making a tender offer to purchase 5% or more of the shares of a class
of securities registered under the 1934 Act must file a report with the SEC, the
issuer and the exchange on which the shares are traded.
c.
The report must include background information about the purchaser, the source
of her funds and her purpose in buying.
Insiders Must Report
a.
07-48
Insiders are officers, directors, more than 10% stockholders, accountants or
attorneys of a company registered under the 1934 Act.
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Regulation 7
b.
Insiders must file a report with the SEC disclosing their holdings in the reporting
company and make monthly updates.
c.
The 1934 Act also limits insider trading by imposing absolute liability on any
insider who makes a profit on the purchase or sale of a reporting company's
stock within a six-month period (called short swing profits).
Proxy Solicitations and Proxy Statements Must be Reported
a.
A proxy solicitation is a written request for permission to vote a shareholder's
shares at a shareholder meeting. Proxy solicitations in reporting companies
must be reported to the SEC.
b.
If directors are to be elected at a meeting for which management is seeking
proxies, an annual report with an audited balance sheet and profit and loss
statement must be sent to all shareholders entitled to vote.
c.
Proxy statements must be sent to all stockholders disclosing all facts that are
pertinent to the matter on which the stockholders will vote. Proxy statements and
any other documents that will be sent to shareholders as part of the proxy
solicitation must be filed with the SEC.
d.
Shareholders have a right to have proposals proper for consideration at the
shareholders' meeting included in management's proxy solicitation.
Section 18 Liability
Under Section 18, a person can be held liable for intentionally making false and/or
misleading statements in a registration statement or any report required under the 1934
Act.
PASS KEY
~
Candidates must know the three periodic reports (10K, 10Q and 8K). Frequently examiners only ask the
names of the other required reports. These may be learned by the memory device "5% TIP" (5% for 5% or
more owners must report; T for Tender offers must be reported; I for Insider trading must be reported; and P
for ~roxy solicitations and Proxy statements must be reported).
D.
Antifraud PrOVisions-Rule 10b-5
1.
2.
]'iffliiUiil
In General-Rule 10b Applies Even if Registration is Not Required
a.
Rule 10b-5, promulgated by the SEC under Section 10(b) of 1934 Act, prohibits
fraud in connection with the purchase or sale of any security.
b.
Rule 10b-5 applies whether or not the securities are of a registered company.
Anyone who sells or buys securities using fraud can be Iiabie.
c.
Violation of rule 10b-5 can result in civil damages, an SEC injunction action, or
criminal fines and penalties.
General Elements of Cause of Action
To recover damages for violation of rule 10b-5, a plaintiff must prove:
a.
Plaintiff Bought or Sold Securities
Rule 1Ob-5 applies only if the plaintiff bought or sold securities.
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b.
I CPA Exam Review
Suffered a Loss
The purchaser must prove he suffered a loss as a result of the fraUd.
c.
Material Misrepresentation or Material Omission of Fact
The plaintiff must prove the defendant made a material misrepresentation or
material omission of fact in connection with the sale.
EXAMPLE
Dee calls Pete and tells him that she holds Bigco stock with a market value of $50, but she will
sell it to him for $25 per share. In fact, the stock's market value is $15. Pete buys Dee's stock.
The fraud here was in connection with a purchase and sale.
EXAMPLE
Pete is Bigco's largest stockholder. To keep Pete from selling Bigco stock, Dee, the president of
Bigco, tells Pete she is about to announce Bigco had large profits during the past year. In fact,
Bigco incurred huge losses. Pete holds onto his stock, and the value of his stock plummets
after Dee announces the loss. The fraud was not in connection with a purchase or sale of stock
since Pete neither bought nor sold any shares.
[email protected]
d.
e.
Scienter (Intent to Deceive or Reckless Disregard for the Truth)
(1)
The plaintiff must show scienter (i.e., the defendant intended to deceive or
made false statements with a reckless disregard for the truth).
(2)
Negligence on the part of the defendant is not sufficient to satisfy this
element.
Reliance
The piaintiff must have relied on the defendant's misrepresentation.
f.
Interstate Commerce
The plaintiff must show that a means of interstate commerce was involved. Any
use of the mail or phones or a national securities exchange is sufficient to satisfy
this element.
EXAMPLE
Becky, a CPA, audited financial statements of Harco. Becky intentionally gave an unqualified opinion
on the financial statements even though she discovered material misstatements. The financial
statements and Becky's unqualified opinion were included in a registration and prospectus for an
original offering of Harco stock. Becky can be held liable for a violation of Rule 10b-5 (and also under
Section 11 of the 1933 Act).
R7·50
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Regulation 7
PASS KEY
1t~'keyt<>te<:6gnlz~thedifferel\ces be~eel\ ~n action under Section 11 ofthe 1~33 Acta,,~under
,uleitli),S.
,.'
-.
.
.
.
oSt!ction 1i of 1933 requires no proof of sdenter, reliance or negligence. The plaintiff need only
shoY/that he acquired the stock and suffered a loss, and that there was a material
misrepi'esl2!ntation or material omission of fact in the registration statement.
3.
o
Rulel0b-S of the 1934 Act requires proof of both scienter and reliance. Plaintiff must show he
bought or sold the stock, suffered a lossl a material misrepresentation or material omission of
fa.ctl Scienter and reliance.
,.
Proof ofnegligence is insufficient under rule lOb-5.
Insider Trading under Rule 10b-5
[II
Under rule 10b-5, it is illegal for a person to trade on the basis of "inside" information if
the person would breach a duty of trust owed to the issuer of the security or the
sharehoiders of the issuer.
a.
Basically, inside information is any material, nonpublic information about the
security or the issuer.
b.
Typically, a securities issuer's insiders, such as directors, officers, controlling
shareholders, and employees of the issuer will be held to owe a duty of trust and
confidence. But outsiders, such as an issuer's CPAs, attorneys, and even
printers may also be held to owe a duty of trust.
c.
A private person injured by a violation of rule 1Ob-5 can bring an action against
the person violating the rule for any actual damages (not punitive damages) or
seeking rescission of the transaction. The SEC can impose fines and seek
criminal penalties.
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Source of misleading statement
Must be in registration
Can be any written or oral
or omission
statement
statement or omission
Transactions covered
Issuance of a security
Sale or purchase of a security
Securities covered by the
Any securities, whether or not
registration statement
publicly traded or registered
Securities covered
Plaintiffs
Defendants
Any person acquiring the
Any purchaser or seller of the
security; SEC
security; SEC
• Every person who signed the
registration statement
• Directors
• People named in the
registration statement
• Experts (including
accountants)
Anyone responsible for the
false statement or omission, or
who trades on the basis of
material, nonpublic
information and who breaches
a duty of trust and confidence
by so trading
False statement or omission
False statement or omission
must be material
must be material
Loss
Must prove
Must prove
Reliance
Need not prove
Must prove
Causation
Need not prove
Must prove
Scienter
Need not prove
Must prove
Knowledge of false statement
Plaintiff cannot know of false
Plaintiff cannot know of false
or omission
statement or omission
statement or omission
Remedies
Rescission or monetary
Rescission or monetary
damages (section 12); criminal
damages
Materiality
damages (section 17)
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Regulation 7
CPA LEGAL LIABILITY
I.
INTRODUCTION
CPA legal liability can arise in any of the following ways: breach of contract, commission of a tort
(e.g., negligence, fraud, or constructive fraud), or violation of a statute.
II.
BREACH OF CONTRACT
A.
In General
If a CPA does not fulfill the terms of his engagement, the client can hold the CPA liable for
breach. Contract liability generally requires privity, so only a party to the contract can sue
under a contract theory.
B.
III.
Damages
1.
Where a CPA breaches the contract, the client or third party beneficiary is entitled to
recover compensatory damages (sufficient money to compensate for the contract not
having been performed).
2.
If the CPA's breach is material, the CPA cannot recover any payment.
3.
Of course, all defenses that were mentioned in the contract outline apply to a contract
made by a CPA (e.g., client's failure to let the CPA see any accounting records is a
failure to cooperate and is a valid defense).
COMMISSION OF A TORT
A.
In General-Negligence, Fraud and Constructive Fraud
CPA liability can also arise from commission of a tort. Three torts are relevant: negligence,
constructive fraud (also called gross negligence), and fraud.
B.
I-I
Negligence
As a generai rule, a CPA owes a duty to his or her client not to perform work negligently. If
the CPA performs negligently, he or she can be held liable for damages.
1.
Elements in General
To make out a case for negligence, the plaintiff must show:
2.
a.
The defendant owed a duty of care to the plaintiff;
b.
The defendant breached that duty by failing to act with due care;
c.
The breach caused plaintiffs injury; and
d.
Damages.
To Whom is the Duty Owed?
a.
[U'@:N'1
A CPA's duty to act with reasonable care generally runs only to
clients and, under the majority rule, to any person or limited
foreseeable class of persons whom the CPA knows will be relying on the CPA's
work.
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b.
A minority of states follows the Ultramares decision, which limits CPA liability
more narrowly to persons in privity of contract with the CPA (clients) and
intended third party beneficiaries.
c.
It is a defense that the plaintiff is neither a client nor a person whom the CPA
knows will be relying on the audit.
EXAMPLE
3.
4.
Alex is hired by Becky to perform an audit of her business's financial statements. Becky
explains to Alex that her bank is requiring the audit before it will give Becky a loan. Alex owes
both Becky and the bank a duty not to perform negligently, but no duty is owed to the bank's
customers because they will not be relying on the audit and are not a limited class. Thus, if
Alex performs negligently, Becky defaults, and the bank goes bankrupt, the bank's customers
cannot sue Alex for negligence.
(2)
Ann is hired by Claire Corp to audit Claire's financial statements in connection with a public
offering of Claire's stock. Ann negligently misses a material misstatement of fact in the
financial reports and signs the registration statement. Phil purchases some Claire Corp stock
and suffers a loss because of the error. Phil cannot recover in negligence from Ann. Although
Phil was within a foreseeable class of persons who might rely on the audited financial
statements, the class is not sufficiently limited.
Breach-Failure to Act with Due Care
a.
A breach occurs when the CPA fails to act with reasonable care.
b.
The standard of care owed by a CPA is to perform with the same skill and care
expected of ordinarily prudent CPAs under the circumstances.
c.
The best evidence that a CPA has acted like a reasonably prudent CPA is that
the CPA followed applicable standards for the profession (e.g., followed GAAS in
an audit or followed GAAP with regard to financial statements).
d.
Following GAAS or GAAP is not an absolute defense. On rare occasions
following GAAS or GAAP can make a report or the financial statements
misleading.
Causation
The damages must have been caused by the CPA's negligence (e.g., when the plaintiff
knows of the CPA's error in sufficient time to avoid damages the court will find no
causal connection between the negligence and the loss).
1111'1
C.
(l)
Fraud and Constructive Fraud (Gross Negligence)
CPA liability can also arise through fraud or constructive fraud.
1.
•
Rl-54
Elements of Actual Fraud-Intentional Misrepresentation
Actual fraud has five elements:
a.
A misrepresentation of material fact;
b.
Intent to deceive (knowing the statement was false);
c.
Actual and justifiable reliance by plaintiff on the misrepresentation:
d.
An intent to induce plaintiffs reliance on the misrepresentation; and
e.
Damages.
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2.
3.
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Regulation 7
Elements of Constructive Fraud (Gross Negligence)
a.
Constructive fraud has the same elements as actual fraud, except instead of
intentionally deceiving, the defendant acts recklessly (i.e., makes a statement
without knowing whether it is true or false).
b.
Constructive fraud is sometimes called gross negligence.
To Whom is CPA Liable?
a.
A CPA's liability for fraud and constructive fraud is much broader than a CPA's
liability for negligence. The CPA can be held liable to anyone who proves the
above elements.
b.
Privity is not a defense to fraud. Liability is not limited to persons in privity, third
party beneficiaries or a limited class of persons who foreseeably rely. All
foreseeable victims can sue.
SUMMARY OF "LEVELS OF FAULT"
1.
"Reasonable Care" ("due care") is taken::: No Negligence::: Not Liable
GAAP and GAAS are guidelines as to what constitutes "reasonable care."
2.
lack of Reasonable Care::: Ordinary Negligence
The CPA is liable to anyone he knows or reasonably should expect will rely on his/her
work.
3,
lack of Even Slight Care = Gross Negligence or Constructive Fraud
The CPA is liable to all people who rely on the F/S, even if he/she does not know or
reasonably should not expect such people to rely on the F/S.
4.
Actual Fraud::: Actual Intent to Deceive
The CPA is liable to all people who rely on the F/S, even if he/she does not know or
reasonably should not expect such people to rely on the F/S.
5.
Criminal Fraud::: Actual Intent to Deceive*
levels 1 through 4 are CIVil in nature. Only levelS is CRIMINAL
*
Note the conduct which forms the basis of a Level 4 Civil Fraud Action is the same conduct which
forms the basis for a criminal prosecution (Level 5) by the government.
IV.
CPA STATUTORY LIABILITY
A.
Securities Laws
We have already discussed CPA statutory liability under the securities laws. By way of
review, remember the following:
1.
Section 11 of the 1933 Act
A CPA who signs off on financial statements in a registration statement can be held
liable for misstatements in the financial statements to a plaintiff who (i) acquired the
stock and (ii) suffered a loss if (iii) the financial statement contained a material
misrepresentation or material omission of fact.
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2.
I CPA Exam Review
Rule 10b-5 of the 1934 Act
A CPA can be held criminally or civilly liable for material misstatements or omissions
made in connection with the purchase and sale of securities under rule 1Db-5. The
plaintiff must prove:
a.
She bought or sold the securities;
b.
She suffered a loss;
c.
The defendant made a material misrepresentation or omission of fact;
d.
The misrepresentation was made with scienter (intent to deceive or reckless
disregard for the truth). Negligence is not enough; the plaintiff must show
scienter;
e.
The plaintiff justifiably relied on the misrepresentation; and
f.
Use of some means of interstate commerce (e.g., telephone, Internet, mail, etc.).
0...---
----.
AN elL L A R V MAT E R I A L (for Independent ReView)
3.
•
Private Securities Litigation Reform Act
A CPA has certain duties when performing an audit of a company registered under the
1934 Securities Exchange Act.
a.
Each audit required pursuant to the 1934 Act must include:
b.
c.
R7-S6
Audit Requirements
(1)
Procedures designed to detect illegal acts that would have a direct and
material effect on the financial statement;
(2)
Procedures designed to identify related party transactions that are material
to financial statements or otherwise require disclosure; and
(3)
Procedures to evaluate whether there is substantial doubt about the ability
of the issuer to continue as a going concern during the next fiscal year.
Procedure upon Detection
(1)
If the accountant detects information of illegal acts, she must determine the
effect of the illegal act on the issuer's financial statements and inform the
issue~s audit committee of the illegality.
(2)
If the audit committee fails to take action with respect to the illegal act, or
the client has no audit committee, the auditor is to report the conciusions
directly to the client's board of directors.
Notification to SEC
(1)
The issuer's board is to report to the SEC the receipt of any such notice
within one day after receiving it and must furnish the accountant with a
copy of the notice.
(2)
If the CPA fails to receive a copy of the notice within one day, the CPA is to
furnish the SEC with a copy of the report within one day.
(3)
The CPA may resign from the audit before notifying the SEC.
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d.
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Regulation 7
Limit on Liability
An accountant is not liable in a private action for findings or conclusions made
pursuant to these rules.
e.
Civil Liability
An accountant who willfully violates these requirements may be fined.
4.
Sarbanes.Oxley Act
Under the Sarbanes-Oxley Act it is a crime:
a.
To knowingly alter, destroy, falsify, etc., a document with the intent to impede a
federal investigation;
b.
For auditors to fail to keep all workpapers related to a public company for at least
seven years; and
c.
To defraud the public in connection with a registered security.
o
END OF ANCILLARY MATERIAL
B.
Privileges
I_I
The rules of evidence protect information exchanged in certain confidential
relationships (e.g., attorney-client, doctor-patient) by granting an eVidentiary
privilege-information exchanged within the scope of the relationship may not be disclosed as
evidence in court without the consent of the privilege holder.
1.
2.
Generally No Accountant·Client Privilege under Federal Law
a.
Despite the confidential nature of a client's financial information, generally federal
law does not recognize an accountant-client privilege.
b.
A CPA can be forced to disclose client information, including workpapers, if
subpoenaed and relevant to a federal court case.
Generally No State Privilege
a.
Most states follow the federal view and do not grant a privilege for accountantclient communications.
b.
When the privilege does exist, state courts and agencies have no power to force
a CPA to disclose confidential client information.
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Regulation 7
C.
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I CPA Exam Review
Workpapers
1.
Disclosure Generally Prohibited
a.
Workpapers belong to the accountant (or accountant's firm) that prepares them,
not the client.
b.
The accountant is prohibited from showing the workpapers to anyone without the
client's permission except for the following:
(1)
An accountant must show the workpapers if they are subpoenaed and
relevant to a court case;
(2)
The workpapers may be shown to a prospective purchaser of the CPA's
practice, as long as the prospective purchaser does not disclose the
confidential information;
(3)
Workpapers must be turned over to a state CPA society voluntary quality
control review panel when requested;
(4)
To defend a lawsuit brought by a client;
(5)
Official investigation of the AICPA/state trial board; and
(6)
GAAP/GAAS requires disclosure.
PASS KEY
Notethat while a CPA may allow a prospective purchaser to review confidential workpapers, the CPA may not
turn over the workpapers to a purchaser without the client's permission.
R7-58
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Regulation 7
ANTITRUST LAW
.----
~o
AN elL L A R Y MAT E R I A L (for Independent Review)
I.
II!llll!!III
INTRODUCTION
The antitrust laws generally prohibit businesses from engaging in conduct that could stifle free
competition. They are based on the theory that free competition will force businesses to compete,
and to compete successfully businesses will have to offer better products at lower prices.
Congress passed the first antitrust statute in 1890. the Sherman Antitrust Act. Since then.
Congress has passed a number of other antitrust statutes. including the Clayton Act. the RobinsonPatman Act. and the Federal Trade Commission Act.
II.
SHERMAN ACT-PROHIBITS RESTRAINTS OF TRADE AND MONOPOLIES
IIM;',fjU'1
The Sherman Act has two prominent sections. Section 1 prohibits contracts. combinations and
conspiracies that restrain trade. Section 2 prohibits monopolies and attempts to monopolize. The
Sherman Act only applies to activities that have a significant impact on interstate commerce.
A.
Section 1-Restraints of Trade
1.
Rule of Reason Test: Balance Anticompetitive and Competitive Effects
IIBI
Section 1 only prohibits agreements that unreasonably restrain trade.
Courts balance the anticompetitive and competitive effects of the restraint.
."
This standard is known as the rule of reason test. In applying the rule of reason test.
courts consider:
a.
2.
The nature of the business involved;
b.
The defendant's position in the industry (e.g., market leader, middle of
the pack. minor player);
c.
How the restraint will likely affect the industry; and
d.
The purported goal of the restraint (e.g .. to achieve economies of scale vs. to
crush competition).
Per Se Violations-Inherently Illegal and Without Legal Justification
Certain categories of restraints are inherently illegal by their very nature and.
thus, are illegal per se.
3.
•
•
...
•••
'
•••
IIIIIi1
a.
Plaintiff need only show this type of restraint occurred; (s)he need not show that
the restraint limited competition.
b.
Defendant may not defend by showing the restraint was reasonable.
Horizontal Restraints -Agreements Between Competitors
I~I
a.
Horizontal restraints involve agreements between industry players that
are on the same marketing level (e.g .. agreements between two competing
manufacturers or between two competing retailers).
b.
Horizontal restraints are generally illegal per se.
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•
Becker Professional Education
4.
5.
.'
.
6.
I'Mi';m;1
•
7.
8.
1&;.w'l
• 7·60
Vertical Restraints-Agreements by Those at Different Marketing Levels
a.
Vertical restraints are agreements between industry players that are on different
marketing levels (e.g., an agreement between a television manufacturer and a
retailer).
b.
Vertical restraints are generally judged by the rule of reason test.
Concerted Action Requirement-Action by Two or More Parties
One business cannot violate Section 1 by itself-violation requires concerted action
between at least two parties.
•••
....
I CPA Exam Review
a.
A business can refuse to deal with whomever it likes, as long as it does so
independently.
b.
An agreement between a corporation and a wholly owned subsidiary does not
violate the Sherman Act. They are viewed as one entity.
Price Fixing-Agreements to Set Prices for Goods or Services
a.
Horizontai price fixing (i.e., agreements among competitors to fix prices) is a per
se violation of the Sherman Act.
b.
Attempts by manufacturers to control the resale price of their products are
vertical price fiXing-usually called resale price maintenance.
(1)
A Supreme Court decision calls into question whether vertical price fixing is
per se illegal or judged by the rule of reason.
(2)
In State Oil Co. vs. Khan (1997), the Supreme Court ruled that vertical
maximum price fixing (i.e., setting the maximum price for sale of a
manufacturer's products) was not a per se violation. Vertical maximum
price fixing is to be judged by the rule of reason test.
Market Allocations-Agreements Not to Compete in Specific Markets
a.
Horizontal market allocations (i.e., attempts by competitors to divide up markets
or customers) are a per se violation. Horizontal market allocations can occur at
the manufacturing, wholesale or retail level.
b.
Vertical market allocations are judged by the rule of reason test.
Boycotts-Two or More Firms Agree Not to Deal with a Third Party
a.
A single firm may refuse to do business with whomever it chooses.
b.
Horizontal agreements to boycott a product, manufacturer, distributor, or the like
are considered illegal per se if they are designed to eliminate a competitor or to
make the competitor conform to the group.
c.
Other boycotts are judged by the rule of reason (e.g., vertical boycotts and
horizontal boycotts for political reasons).
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10.
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Regulation 7
Tying Arrangements-Must Buy One Product to Get Another
a.
A tying arrangement arises when a seller requires a buyer to
purchase a second product in order to obtain a more desired
product.
b.
Tying arrangements are per se illegal if the seller has a considerable amount of
economic power in the tying product market.
c.
If the seller lacks economic power, the tying arrangement is judged by the rule of
reason.
Joint Ventures and Trade Associations
1"1
a.
A joint venture is a combined effort by two or more businesses for a
limited purpose such as research. Joint ventures by competitors can
violate antitrust law.
b.
A joint venture not formed to fix prices or divide markets will be judged under the
rule of reason test.
c.
The National Cooperative Research Act of 1984 provides that joint ventures in
the research and development of new technology are to be judged under the rule
of reason test.
d.
Businesses in the same industry frequently form trade associations to promote
common interests. Trade associations not formed to fix prices or divide markets
will be judged by the rule of reason test.
RESTRAINTS OF TRADE UNDER SHERMAN ACT
Type
Rule of Reason
Per Se Illegal
Price fixing
Horizontal price fixing
Vertical (probably)
Market allocation
Horizontal market allocation
Vertical market ailocation
Boycott
Horizontal-if designed to eliminate a
competitor or force compliance
Vertical boycotts and other horizontal
boycotts
If seller has considerable economic
power in the tying product
power
If formed to fix prices or divide markets
All other joint ventures and trade
Tying arrangements
Joint ventures and
trade associations
If seiler lacks sufficient economic
associations
PASS KEY
In learning the types of restraints that are illegal per se and those judged by the rule of reason remember:
•
Most horizontal restraints are illegal per se (e.g., price fixing, market allocation and boycotts designed to eliminate
a competitor or coerce compliance).
•
Most vertical restraints are judged by the rule of reason (vertical price fixing in all likelihood, vertical market
allocation and vertical boycotts).
Thus, to see if an activity is illegal per se, it is beneficial to first check to see it is a horizontal or vertical restraint.
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Regulation 7
B.
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I CPA Exam Review
Section 2-Monopolies and Attempts to Monopolize
Section 2 of the Sherman Act prohibits monopolies and attempts to monopolize. Unlike
section one, which requires concerted action, section two prohibits both agreements and
unilateral action by a single business.
1.
I'MlIMNMI
Monopolies
a.
b.
c.
2.
Courts require two elements to establish an illegal monopoly:
(1)
Monopoly power and
(2)
Achieved the power unfairly or abused the power once achieved.
Monopoly power exists when a firm has sufficient market power to control prices
or exclude competition.
(1)
A company that has a market share of more than 70% generally is
considered a monopoly.
(2)
A company that has a market share of less than 40% generally will not be
considered a monopoly.
(3)
Companies with market shares of between 40% and 70% mayor may not
be monopolies.
By its very nature a patent grants a limited monopoly to the patent holder. The
patent holder may sell the item at whatever price it desires without violating the
Sherman Act.
Attempts to Monopolize
For an attempt to monopolize to be illegal, courts have required proof of a specific
intent to exclude or to exercise monopoly power and also proof of a high probability of
success.
C.
Enforcement of the Sherman Act
1.
2.
R7-62
Government Action
a.
Only the Justice Department may file criminal and civil actions in federal court
against companies for failure to comply with the Sherman Act. Violations are
felonies and may be punished by fines and imprisonment.
b.
Federal courts may also issue injunctions prohibiting violations, compelling
divestiture of subsidiaries, canceling contracts, andlor dividing the company's
assets to create a competing entity.
c.
States may also bring actions on behalf of their citizens for treble (I.e., triple)
damages.
Private Actions for Treble Damages
a.
Persons injured by violation of the Sherman Act may bring civil suits to recover
treble damages and attorneys' fees.
b.
They must show a direct injury as a result of anticompetitive behavior.
c.
Participants in the anticompetitive behavior may not sue.
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III.
I CPA Exam Review
Regulation 7
CLAYTON ACT
The Clayton Act was aimed at anticompetitive behavior not covered by the Sherman
Act. It was intended to stop such activities in their incipiency (Le., stop them before they
become violations of the Sherman Act).
A.
B.
General Provisions
1.
Illegal activities are stated in four sections: section two (price fixing), section three
(exclusive dealing contracts and tying arrangements), section seven (mergers) and
section eight (interlocking directorates).
2.
Proscribed activities are illegal only if they tend to substantially lessen competition or
tend to create monopoly power.
3.
Unlike the Sherman Act, the Clayton Act is civil in nature, not criminal.
Section 3-Tying Arrangements and Exclusive Dealing
1.
Tying Arrangements-Must Buy One Product to Get Another
Tying arrangements are treated the same under the Clayton Act as they
are under the Sherman Antitrust Act.
2.
Exclusive Dealing Arrangements
a.
b.
C.
IWM'I
In an exclusive dealing agreement, the seller of goods requires the
buyer to promise not to deal in goods of a competitor (e.g., a
furniture manufacturer prohibits retailers that carry its products from
carrying competing brands).
'-I
•
..•••.
:"
Such arrangements are treated more lenientiy than tying arrangements, but will
be held to violate the Clayton Act if they tend to create a monopoly or may
substantially lessen competition.
Section 7-Mergers and Acquisitions
Section 7 of the Clayton Act prohibits the merger or acquisition of a company If the effect is to
substantially lessen competition. It allows the Department of Justice to proscribe mergers and
acquisitions in their incipiency, before they develop monopoly power.
1.
Horizontal Mergers-Mergers Between Competitors
a.
b.
In determining if a horizontal merger violates the Clayton Act, courts
consider:
•
(1)
Market concentration (Le., the number of competitors that share a market).
If a small number of companies share a large market, the market is
concentrated;
(2)
The market share of the acquirer after the merger;
(3)
The trend towards concentration in the market: and
(4)
Whether the merger was designed to establish market power or restrict
competition.
Horizontal mergers are judged more stringently than other types.
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2.
•
I CPA Exam Review
Vertical Mergers-Firm Acquires its Customers or Suppliers
a.
A forward vertical merger occurs when a firm acquires a customer.
b.
A backward vertical merger occurs when a firm acquires a supplier.
c.
With vertical mergers courts focus almost exclusively on the likelihood that
competition may be foreclosed in a substantial share of the market.
Conglomerate Merger-Between Those in Different Businesses
4.
a.
In a conglomerate merger, a firm acquires a company in a completely different
business (Le., a merger between firms that neither compete nor have a
customer/supplier relationship).
b.
Conglomerate mergers have only been challenged when one of the merging
firms is highly likely to enter the market of the other or where the merged
company would become disproportionately large.
Failing Company Exception-Permissible if No Other Buyer
If the acquired firm is in danger of becoming insolvent and no other purchasers are
interested in acquiring it, a merger can be lawful even if the effect is to lessen
competition.
D.
1_1
Section 8-lnterlocking Directorates
1
.
2.
•
E.
R7-64
a.
Section 8 only prohibits interlocking directorates in competing firms.
b.
Interlocking directorates in competing firms is permissible if the overlap in
competition is insignificant.
Section 8 does not apply to banks, banking associations, trust companies, and common
carriers.
Robinson-Patman Act
The Robinson-Patman Act of 1936 amended and strengthened section 2 of the Clayton Act
that prohibited price discrimination.
1.
2.
I-I
Section 8 of Clayton prohibits competing corporations engaged in interstate commerce
from having common directors (interlocking directorates).
General Provisions
a.
Section 2 of the Clayton and Robinson-Patman Acts only apply to price
discrimination of commodities of like grade and quality. They do not cover price
discrimination involving services, real estate or intangibles.
b.
Robinson-Patman prohibits both sellers and buyers from price discrimination only
if it substantially lessens competition or tends to create a monopoly.
c.
It prohibits buyers from inducing and sellers from granting discounts of any type
(e.g., allowances for advertisements, samples, special financing, etc.).
Types of Anticompetitive Effects
a.
Primary-Line Injury-Injuries to a Seller's Competitors
(1)
Price discrimination that causes injury to a seller's competitors are called
primary-line injuries.
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(2)
b.
c.
Regulation 7
Plaintiff must prove intent to harm competition through predatory pricing or
show price discrimination actually harmed competition.
Secondary-Line Injury-Injuries to a Seller's Customers
I-I
(1 )
Robinson-Patman amended Clayton to protect small buyers
from being harmed by discounts sellers gave to iarge buyers.
(2)
Plaintiff must prove substantial and sustained price differences in a market
or show price discrimination actually harmed competition.
(3)
Courts will infer harm to competition from a sustained and substantial price
difference between competing purchasers.
Tertiary-Line Injury-Injuries to Customers of a Seller's Customers
'-I
Tertiary-line injuries occur when a customer who is receiving a discriminatory
price passes the benefits on to its customers.
3.
Defenses to Price Discrimination
a.
Cost Justification-Passing Cost Savings on to Customers
A seller may legally pass cost savings on to customers if the seller can prove it
costs less to sell the product. The discount must be given to aI/ buyers in that
group (e.g., quantity discounts for aI/large purchasers).
EXAMPLE
Acme manufactures television sets, Acme realizes substantial shipping cost savings for large
quantity purchases. Acme gives quantity discounts that reflect its savings to all large quantity
purchasers.
b.
Changing Conditions-Temporary Conditions Affecting a Market
Price discrimination is permissible for temporary situations caused by the
physical nature of the goods (e.g., charging a cheaper price for deterioration of
perishable items, selling seasonal items out of season, forced judicial saies,
etc.).
c.
Meeting Competition-But Cannot Price to Beat Competition
Price discrimination is permissibie to meet, but not beat, an equally low price of a
competitor in a given area.
F.
Enforcement of Clayton and Robinson-Patman
1.
~
The Federal Trade Commission and the Department of Justice can enforce Clayton and
Robinson-Patman through civil actions, not criminal actions.
a.
They may ask courts to order divestiture (i.e., ordering a firm to give up one or
more of its operating functions) or dissolution.
b.
They may seek injunctions to prevent further violations.
c.
They may issue cease and desist orders (i.e., an order to a firm to stop its
anticompetitive behavior).
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2.
IV.
I CPA Exam Review
Private parties harmed can sue for treble damages and attorney's fees.
a.
Private parties must show they were directly harmed by the violations.
b.
Firms participating in the anticompetitive behavior may not sue.
FEDERAL TRADE COMMISSION ACT
In 1914 Congress passed the Federal Trade Commission Act and created the Federal Trade
Commission (FTC).
A.
•
Prohibited Activities
1.
2.
B.
V.
a.
To be "unfair" a method of competition or practice must be substantial, it must
not be outweighed by any countervailing benefits to consumers and it must be an
injury that consumers could not avoid.
b.
To be "deceptive" there must be a misrepresentation, omission, or practice that Is
likely to mislead a reasonably acting consumer.
The Act also prohibits advertisements without a reasonable basis for their claims.
Enforcement of the Act-No Private Party Suits Permitted
1.
The FTC has the power to seek preliminary and permanent injunctions.
2.
The FTC has the power to issue cease and desist orders.
3.
The FTC can require advertisers to make affirmative disclosures (i.e., include
information so that the ad is not deceptive) and may also require corrective
advertisements (admit in advertisements that previous ads were deceptive).
4.
The Act does not permit private party lawsuits for treble damages.
EXEMPTIONS FROM ANTITRUST LAWS
A.
B.
o
The Act makes illegal unfair methods of competition and is not confined to activities that
were prohibited under the Sherman or Clayton Acts. It also prohibits unfair or deceptive
practices.
Statutory Exemptions from Antitrust Law
1.
Labor unions are permitted to organize and bargain without violating antitrust law under
the Clayton Act.
2.
Agricultural associations are also exempt from antitrust laws by Clayton.
3.
The insurance business has a partial exemption.
4.
American exporters may engage in joint export activities as long as the activities do not
restrain trade within the United States.
5.
Cooperative research among small businesses is exempt.
Judicial Exemptions from Antitrust Law
1.
Businesspersons may join together to obtain legislative or executive action.
2.
Professional baseball is exempt from antitrust law.
END OF ANCILLARY MATERIAL
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I CPA Exarn RevielN
Regulation 7
COPYRIGHTS AND PATENTS
AN C III A R Y MA T E R I A l
I.
COPYRIGHTS
A.
©
(for Independent Review)
.
-
~""Jl
Introduction
A copynght IS a federal right that gives authors of originai works certain rights to control the
reproduction of the work.
B.
What Works May Be Protected?
Copyright protection extends to original works of authorship in any tangible medium of
expression. The foiiowing is a nonexhaustive list of the types of work protected by copyright
iaw:
(i)
Literary works, such as books;
(ii)
Musical works (both lyrics and musical scores) and choreographic works;
(iii)
Pictures, whether painted, drawn, photographed, etc.;
(iv)
Films;
(v)
Sculptures;
(vi)
Computer programs (but it is generally agreed that the look of a user interface-such
as how Windows ™ appears-is not protected by copyright);
(vii)
Architectural works; and
(viii) Foreign language reproduction of a copyrighted work.
1.
What Is Not Protected?
Procedures, processes, concepts, etc., are not protected by copyright. For example,
the script of the movie Pocahontas is protected by a copyright. But the idea of a young
girl attuned to nature befriending an alien, teaching him the ways of her people, and
having him be accepted by her tribe is not protected by copyright (hence we have the
movie Avatar).
C.
What Are the Rights?
A copyright gives its owner the exclusive right to:
(i)
Reproduce the work;
(ii)
Prepare derivative works based off the work;
(iii)
Distribute copies of the work (e.g., by selling it, licensing it, etc.); and
(iv)
Perform or display the work publicly.
1.
Limitation-Fair Use Doctrine
The fair use doctrine aiiows use of a copyrighted work without the owner's permission
for purposes of:
© 2010
DeVry/Bec~er
(i)
Criticism and comments (e.g., movie or book reviews);
(ii)
News reporting; and
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R7-67
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(iii)
I CPA Exam Review
Teaching (including multiple copies for classroom use).
In determining whether the use of a copyrighted work is fair, the courts will consider a
number of factors, including the purpose of the use, the nature of the work, the amount
of the work that was used (e.g., the entire book, a chapter, a few sentences); and the
effect of the use on potential markets.
2.
Rights Arise Automatically, But Must Register to Enforce Rights
Copyright protection is automatic. It arises as soon as an author/creator fixes his or
her work in a tangible medium of expression. However, to be able to enforce
copyrights in court, the copyright owner must generally register the copyright with the
federal Copyright Office.
D.
Who Owns the Copyright?
Typically, the creator of a copyrighted work owns the copyright. Exceptions:
(i)
If the work was created by an employee for his or her employer within the scope of
employment, the employer owns the work.
(ii)
If someone commissioned the work to be created (work for hire-such as was done
with the text you are reading now) the person commissioning the work is the owner (in
the case of this book-Becker CPA).
1.
Rights Transferable if In Writing
Ownership of a copyright may be transferred, but the transfer must be memorialized by
a writing signed by the copyright owner.
E.
Protection
In a suit for copyright infringement, the copyright owner need only prove ownership and a
violation of one of the above rights.
(i)
The owner does not have to prove fault (i.e., even an unintentional infringement is
actionable).
(Ii)
The owner does not have to prove that the entire work was taken; use of a substantial
part of the work can be sufficient.
1.
Remedies
The following remedies are available:
R7-68
(i)
Injunction;
(ii)
Impoundment of the offending material;
(iii)
Damages, including profits made by the infringer or statutory damages of
between $500 and $20,000 (or $100,000 if the infringement was willful);
(iv)
Costs of bringing the suit; and
(v)
A criminal fine of up to $250,000 or five years imprisonment (the highest
penalties are available only for cases of large scale piracy of recordings or
movies under an amendment to the copyright laws known as the No Electronic
Theft Act or NETA); note that NETA does not require sale of the pirated material;
just large scale distribution.
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2.
I CPA Exam Review
Regulation 7
How Long do Rights Last?
A copyright owned by an individual iast for the author's life plus 70 years. A copyright
owned by a company lasts for 95 years from the time it was first published or 120 years
from its creation, whichever is earlier.
II.
PATENTS
A.
What Works May Be Protected?
A patent is a federai right to protect an invention, process, or design that is: (i) novel; (ii)
useful; and (Iii) not obvious to a person skilled in the area. Things that may be protected by
patents include:
(i)
Machines;
(ii)
Chemical compounds (such as drugs);
(iii)
Plants produced by asexuai reproduction;
(iv)
Genetically engineered bacteria; and
(v)
Computer programs.
1.
What Is Not Protected?
Naturally occurring substances (e.g., piants), abstract ideas, laws of nature, and ideas
may not be patented. Neither may business methods, such as new accounting
techniques.
2.
Must Apply to U.S. Patent and Trademark Office
Unlike copyright protection, patent protection is not automatic. It arises only upon
issuance of a patent by the U.S. Patent and Trademark Office (PTO). The application
for a patent must include desig n specifications that describe how the product works,
drawings, and an explanation of why it is patentable.
B.
Who Owns the Patent?
Typically, the creator of the patented item owns the patent. Exceptions:
(i)
If the work was created by an employee for his or her employer within the scope of
employment, the employee owns the patent but must use it for the employer's benefit
and must assign the right to the employer.
(ii)
If the employee was not hired to create the patented product, but used the employer's
facilities to create the product, the employer has the shop right to nonexclusive use of
the patent without paying a royalty.
1.
Rights Transferable if In Writing
Ownership of a patent Is transferable, but the transfer must be memorialized by a
writing signed by the patent owner.
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R7-69
Regulation 7
C.
Becker Professional Education
I CPA Exam Review
Protection
If a patent is granted, the owner of the patent has the exclusive right to make, use and sell the
invention for which the patent was issued.
1.
Remedies
The following remedies are available if another uses a patented design, product, or
process without the owner's permission:
2.
(i)
Injunction;
(ii)
Damages at least equal to a reasonable royalty for using the patent; treble
damages if the unauthorized use was intentional; and
(iii)
Attorneys' fees and costs of bringing the suit.
Possible Defense-Patent Improperly Granted
One possible defense to a patent infringement suit is that the patent should not have
been issued-that the product or design was not truly novel, useful, and nonobvious.
3.
Lack of Knowledge is No Defense
Anyone who, without permission, uses or sells a patented invention is liable as a direct
infringer. Good faith and lack of knowledge are not valid defenses to direct
infringement.
4.
How Long Do Rights Last?
A patent lasts for 20 years for most inventions; 14 years for design patents.
o
END OF ANCILLARY MATERIAL
R'·70
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Review
CLASS QUESTIONS
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3.
4.
5.
6.
7.
8.
9.
10.
ll.
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14.
15.
16.
1st
Multiple-choice questions correct + 16 questions:::
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2nd
Multiple-choice questions correct + 16 questions:::
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3rd
Multiple-choice questions correct +-16 questions -
%
Final
Total questions correct
%
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+ 16 questions:::
right~
reserved.
R7-71
Regulation 7
Becker Profess'lonal Education
I CPA Exam Review
NOTES
© 2010 DeVry{Becker Education.1 Development Corp_ All rights reserved.
Becker Professional Education
I (PI\ Exam Review
Regulation 7
1. CPA-01311
Trent was retained, in writing, to act as Post's agent for the sale of Post's memorabilia collection. Which
of the following statements is correct?
I.
To be an agent, Trent must be at least 21 years of age.
II.
Post would be liable to Trent if the collection was destroyed before Trent found a purchaser.
a.
b.
c.
d.
I only.
\I only.
Both I and II.
Neither I nor II.
2. CPA-01313
When a valid contract is entered into by an agent on the principal's behalf, in a non-disclosed principal
situation, which of the following statements concerning the principal's liability is correct?
The principal may
be held liable
once disclosed
The principal
must ratify
the contract to
be held liable
Yes
Yes
No
No
Yes
No
Yes
No
a.
b.
c.
d.
3. CPA-01318
An agent will usually be liable under a contract made with a third party when the agent is acting on behalf
of a(an):
a.
b.
c.
d.
Disclosed
principal
Undisclosed
principal
Yes
Yes
No
No
Yes
No
Yes
No
4. CPA-01335
North Inc. hired Sutter as a purchasing agent. North gave Sutter written authorization to purchase,
without limit, electronic appliances. Later, Sutter was told not to purchase more than 300 of each
appliance. Sutter contracted with Orr Corp. to purchase 500 tape recorders. Orr had been shown
Sutter's written authorization. Which of the following statements is correct?
a.
b.
c.
d.
Sutter will be liable to Orr because Sutter's actual authority was exceeded.
Sutter will not be liable to reimburse North if North is liable to Orr.
North will be liable to Orr because of Sutter's apparent authority.
North will not be liable to Orr because Sutter's actual authority was exceeded.
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R7-73
Regulation 7
Becker Professional Education
I CPA Exam Review
5. CPA·01376
Which of the following conditions, if any, must a debtor meet to file a voluntary bankruptcy petition under
Chapter 7 of the Federal Bankruptcy Code?
a.
b.
c.
d.
Insolvency
Three or more creditors
Yes
Yes
No
No
Yes
No
Yes
No
6. CPA·01367
Deft, CPA, is an unsecured creditor of Golf Co. for $15,000. Golf has a total of 10 creditors, all of whom
are unsecured. Golf has not paid any of the creditors for three months. Under Chapter 11 of the Federal
Bankruptcy Code, which of the following statements is correct?
a.
b.
c.
d.
Golf may not be petitioned involuntarily into bankruptcy because there are less than 12 unsecured
creditors.
Golf may not be petitioned involuntarily into bankruptcy under the provisions of Chapter 11.
Three unsecured creditors must join in the involuntary petition in bankruptcy.
Deft may file an involuntary petition in bankruptcy against Golf.
7. CPA·01377
Which of the following transfers by a debtor, within ninety days of filing for bankruptcy, could be set aside
as a preferential payment?
a.
b.
c.
d.
Making a gift to charity.
Paying a business utility bill.
Borrowing money from a bank secured by giving a mortgage on business property.
Prepaying an installment loan on inventory.
8. CPA·01382
Which of the following types of claims would be paid first in the distribution of a bankruptcy estate under
the liquidation provisions of Chapter 7 of the Federal Bankruptcy Code if the petition was filed July 15,
Year 3?
a.
b.
c.
d.
A secured debt properly perfected on March 20, Year 3.
Inventory purchased and delivered August 1, Year 3.
Employee wages due April 30, Year 3.
Federal tax lien filed June 30, Year 3.
9. CPA·01365
Strong Corp. filed a voluntary petition in bankruptcy under the reorganization provisions of Chapter 11 of
the Federal Bankruptcy Code. A reorganization plan was filed and agreed to by all necessary parties.
The court confirmed the plan and a final decree was entered.
Which of the following statements best describes the effect of the entry of the court's final decree?
a.
b.
c.
d.
Strong Corp. will be discharged from all its debts and liabilities.
Strong Corp. will be discharged only from the debts owed creditors who agreed to the reorganization
plan.
Strong Corp. will be discharged from all its debts and liabilities that arose before the date of
confirmation of the plan.
Strong Corp. will be discharged from all its debts and liabilities that arose before the confirmation of
the plan, except as otherwise provided in the plan, the order of confirmation, or the Bankruptcy Code.
R7-74
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I CPA Exam Review
Regulation 7
10. CPA-01419
Pix Corp. is making a $6,000,000 stock offering. Pix wants the offering exempt from registration under
the Securities Act of 1933.
Which of the following provisions of the Act would Pix have to comply with for the offering to be exempt?
a.
b.
c.
d.
Regulation
Regulation
Regulation
Regulation
A.
D, Rule 504.
D, Rule 505.
D, Rule 506.
11. CPA-01422
Pix Corp., is making a $6,000,000 stock offering. Pix wants the offering exempt from registration under
the Securities Act of 1933.
Which of the following requirements wouid Pix have to comply with when selling the securities?
a.
b.
c.
d.
No more than 35 investors.
No more than 35 unaccredited investors.
Accredited investors only.
Unaccredited investors only.
12. CPA-01402
Which of the following factors, by itself, requires a corporation to comply with the reporting requirements
of the Securities Exchange Act of 1934?
a.
b.
c.
d.
Six hundred employees.
Shares listed on a national securities exchange.
Total assets of $2 million.
Four hundred holders of equity securities.
13. CPA·01440
Under the liability provisions of Section 11 of the Securities Act of 1933, which of the following must a
plaintiff prove to hold a CPA liable?
I.
The misstatements contained in the financial statements certified by the CPA were material.
II.
The plaintiff relied on the CPA's unqualified opinion.
a.
b.
c.
d.
I only.
II only.
Both I and II.
Neither I nor II.
14. CPA-01445
Which of the following statements is generally correct regarding the iiability of a CPA who negligently
gives an opinion on an audit of a client's financial statements?
a.
b.
c.
d.
The
The
The
The
CPA is
CPA is
CPA is
CPA is
oniy liabie to those third parties who are in privity of contract with the CPA.
only liable to the client.
liable to anyone in a class of third parties who the CPA knows will rely on the opinion.
liable to all possible foreseeable users of the CPA's opinion.
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R7-75
Regulation 7
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15. CPA-01450
Ocean and Associates, CPAs, audited the financial statements of Drain Corporation. As a result of
Ocean's negligence in conducting the audit, the financial statements included material misstatements.
Ocean was unaware of this fact. The financial statements and Ocean's unqualified opinion were included
in a registration statement and prospectus for an original public offering of stock by Drain. Sharp
purchased shares in the offering. Sharp received a copy of the prospectus prior to the purchase but did
not read it. The shares declined in value as a result of the misstatements in Drain's financial statements
becoming known. Under which of the following Acts is Sharp most likely to prevail in a lawsuit against
Ocean?
Securities Exchange
Act of 1934,
Section 1O(b),
Rule 10b-5
Securities Act
of 1933,
Section 11
a.
b.
Yes
Yes
Yes
c.
No
No
Yes
d.
No
No
16. CPA-01452
Which of the following statements is correct regarding a CPA's working papers? The working papers
must be:
a.
b.
c.
d.
Transferred to another accountant purchasing the CPA's practice even if the client hasn't given
permission.
Transferred permanentiy to the client if demanded.
Turned over to any government agency that requests them.
Turned over pursuant to a valid federal court subpoena.
R7-76
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