SECURITIES REGULATION
Professor James Jalil
Exam ID: E
40 short question, 2 min each = 80 min
3 essays, 20 points each x 30 min = 90 min
Well written and give the advice client wants
“Read carefully.”
“Happy as Clams.” “The secret to happiness is love.”
The universal characteristic of those that love all is happiness. We choose what kind of world we want to live
in, we choose whether things are ugly or beautiful. Avoid toxic, hateful people.”
“Buy sell sell buy buy buy sell buy sell sell sell buy buy.”
"Consider the meaning of every sentence…"
"Relax."
“What’s the Howey Test” “How long have to hold a security before
restriction falls away”
Long answer- one client w/ all kinds of issues (30 min ea.)
Issue Checklist / Table of Contents
INTRODUCTION
Generally
1
WHAT IS A SECURITY?
’33 Act § 2(a)(1)
Equity-Like Securities: The Howey Test
2
2
Exceptions to What is a Security
Debt-Like Securities – the “Family Resemblance” Test
Automatic Application of Securities Laws
5
6
7
Securitization
7
SECURITIES ACT OF 1933
Section 5 – Disclosure
- The Pre-Filing Period
- The Waiting Period
- The Posteffective Period
Materiality
Integration Doctrine
Primary Offering Exemptions
§ 4(a)(1) – Exempted Transactions
§ 3(a)(11) – Intrastate Offering Exemption
Rule 147 Sage Harbor
Rule 147A Safe Harbor
§ 4(a)(2) – The Private Offering Exemption
- SEC v. Ralston Purina
§ 3(b)(1) – Small Issues Exemptive Authority
Regulation D
- Rule 504 (and 505)
8
9
10
11
12
13
14
14
15
16
16
16
17
18
19
- Rule 506
- Rule 506(c)
§ 3(b)(2) – Additional Issues Exemption
Regulation A
Special Note on § 3(b) Transactions
§ 4(a)(6) – Crowdfunding Exemption
Regulation S
Secondary Offerings
- § 2(a)(11) – Underwriters
Rule 144 Safe Harbor
§ 4(a)(1)(1/2)
Rule 144A
Exempt Securities
§ 3(a)(2) – Government Securities
§ 3(a)(3) – Commercial Paper
19
19
21
21
22
23
23
28
29
31
32
33
33
1
§ 3(a)(4) – Religious and Fraternal Organizations
§ 3(a)(5) – Savings and Loan Institution Securities
§ 3(a)(8) – Insurance Policies
§ 3(a)(9) – Exchange Offers
Other Exempt Securities
Recapitalizations (Spinoffs and Reverse Mergers)
Liability
Section 11
Section 12
§ 3(b)(2) – Reg A Plus
Section 17
33
34
34
34
34
35
36
38
39
40
SECURITIES EXCHANGE ACT OF 1934
Generally (SOL, Sections)
Rule 10b-5
40
45
Insider Trading
Regulation FD
Rule 14e-3 – Tender Offer Rule
Enforcement of Securities Laws
Ethical Obligations
46
49
49
50
51
SARBANES-OXLEY ACT OF 2002
Public Company Accounting Oversight Board
Auditor Independence
52
52
DODD-FRANK ACT OF 2010
Financial Stability Oversight Counsel
Volcker Rule
Troubled Asset Relief Program
No More Bailouts
54
54
54
54
INVESTMENT COMPANY ACT OF 1940
General
Exemptions
Types of Investment Companies
Additional Provisions
55
55
57
58
INVESTMENT ADVISORS ACT OF 1940
General
61
STATE BLUE SKY LAWS
DERIVATIVES
63
64
2
INTRODUCTION
Email on syllabus
Wealth = Labor + Capital
● Capital used to be controlled by crown and wealthy families (merchant banks- their own capital)
● House of Rothschild bankrolled a lot of wars go to them to ask for money
1. Historical Perspective
a. Merchants/Shippers - Began to form corporations to help spread the risk. Investors bought part of
ship’s inventory (stock)--> this is where we get the word common stock.
b. Civil War= First public issuance of bonds (from the people) – S.P. Chase sold 20 yr war bonds 
capital raised by the PEOPLE. Confeds did same, but bonds became worthless, Southern investors lost
capital plunging South into 100yr depression.
c. Industrial Revolution- companies went to the public to raise money for railroads, steel mills
fraudulent schemes – the only remedy for these schemes was the common law tort action for fraud.
Sold securities, common stock to the American people
d. During Roaring Twenties, issuers—including investment companies—lied to, schemed, and cheated
investors, largely without consequence needed to restore faith in the system
i. Remedies for abuse were stacked against investors. Had to prove CL fraud for relief
1. Materiality, Scienter, Reliance, Causation, Damages. Very difficult to do.
ii. People stopped investing. Capitalist system failed.
e. Turning Point: Stock Market Crash of 1929
i. FDR approach in the New Deal:
Securities Act of 1933
Securities Exchange Act of 1934
Investment Company Act
Investment Advisers Act of 1940.
ii. FDIC insurance- don’t worry about your deposit at the bank because if the bank fails your money is
insured by the federal government
iii. The essence of securities law is DISCLOSURE.
2. How businesses raise capital
a. E.g. A car wash wants to raise money
i. Two ways:
1. 1. Sell ownership interest in company. Ownership Interest = Equity
2. 2. Borrow money from the public and repay later. Borrowing = Debt
a. THREE KINDS of Debt
i. Notes Short-term maturity (1-3 years)
ii. Debentures Medium maturity (5,7, or 9 years)
iii. Bonds Long-term maturity (>10 years and generally secured)
3. Broker-Dealers
a. Broker Someone who puts two people together and takes a commission (STOCK EXCHANGE)
i. NYSE is a broker market. When Goldman and Merrill facilitate trades on behalf of their clients at
NYSE, they are acting as brokers.
1. E.g. Car salesman. Matches buyer with car dealership/company.
b. Dealer Someone who buys and tries to resell at a markup. NASDAQ
1
i.
NASDAQ is a dealer market. When you want to sell 100 shares of Microsoft, you call Merrill, and
Merrill buys them from you and owns them at inventory. Then a buyer comes along and buys the
Microsoft stock from Merrill at a higher price.
ii. Dealer’s profit is not commission but the margin per share between sell price and purchase price
1. E.g. Used car dealership itself.
c. Someone who works for NYSE is a broker. Someone who works for NASDAQ is a dealer.
i. Someone who does both is a broker-dealer
d. OTC- over the counter- stocks that are not sold on NYSE or NASDAQ
Issuer Transactions Those involving sales of securities by an issuer to investors
Trading Transaction The purchasing and selling of outstanding securities among investors
ECNs Electronic Communication Networks
Exchanges
a. Act as gatekeepers for membership, resolve disputes, establish codes for trading practices, and
implement policies to set industry standards
8. Wealth = Labor + Capital
4.
5.
6.
7.
2
WHAT IS A SECURITY?
8/28/17
1. Statutory Definition: §2(a)(1)
a. 2(a)(1): the term “security” means any note, stock, debenture, bond, evidence of indebtedness … and
investment contract.
i. Any “Investment contract” is the default (catchall) definition of a security.
ii. NO distinction between public and close corporation in determining a security for ’33 Act.
iii. Risk is irrelevant
iv. Number of ppl (owners) is irrelevant (4ppl or 4MMppl)
2. ’33 Act § 2(a)(1) WHAT IS A SECURITY- AN INVESTMENT CONTRACT
a. “Unless context otherwise requires, any note, stock, treasury stock, security future, security-based
swap, bond, debenture, evidence of indebtedness, certificate of interest or participation note, stock,
bond, debenture, in any profit-sharing agreement, collateral-trust certificate, reorganization certificate
or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit
for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle,
option, or privilege on any security, certificate of deposit, or group or index of securities (including any
interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered
into on a national securities exchange relating to foreign currency, or, in general, any interest or
instrument commonly known as a ‘security,’ or any certificate of interest or participation in, temporary
or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any
of the foregoing”
1. NOT every NOTE is a security (E.g. consumer note)
2. Note is a promise to pay money
There are 2 types of notes: Equity and Debt
EQUITY-LIKE SECURITIES: THE HOWEY TEST
1. SEC v. W.J. Howey (1946) (Murphy) MOST IMPORTANT TEST- A SECURITY IS A CONCEPT- NOT A
PIECE OF PAPER
a. If ANY instrument, no matter what it is called, meets the Howey test, it IS a security. If it doesn’t meet
the Howey test it may STILL be a security.
b. Facts: Howey wanted to raise capital for orange-growing business. Could have borrowed money or
sold interest in company, but instead, entered into contracts with investors. Sold each investor a line of
orange trees in a grove. Howey would plant, grow, maintain, negotiate, pick, and sell the oranges.
Investors would then get paid. He ran an honest business transaction but the SEC had an issue. The
SEC (plaintiff) brought an action against Howey for using interstate commerce to offer and sell
unregistered securities in violation of § 5(a) of the Securities Act of 1933 (SEA). Howey argued that it
was not offering a security
c. You can’t sell a security without complying with requirements of the Securities Act of 1933
d. Issue: Whether the contract constituted an “investment contract” within meaning of § 2(1) of ’33 Act.
e. Holding: Howey offered and sold “investment contracts” and thus sold “securities” under § 2(a)
HOWEY TEST-
3
f.
Rule: An investment contract for purposes of the ’33 Act means a contract, transaction, or scheme:
(must meet all 3) – but not a bright line
1. Whereby a person invests his money (Investment of $$)
2. In a common enterprise
3. And is led to expect profits solely from the efforts of the promoter or a third party (profits
depend on efforts of other)
a. Success depends on others
b. NOTE: “solely” has been removed from the rule by courts
ii. BUT ALSO ASK, per Marine Bank is there a better regulatory scheme available? OR is transaction
unique?
Howey highlights the Capitalist system--> Wealth is labor plus capital. This allows businesses to function
The question of whether it is risky has nothing to do with the analysis
Whether it is publicly traded or privately held is not part of the analysis
2. SEC v. Edwards (2004) (O’Connor)
a. An investment scheme promising a fixed rate of return can be an “investment contract” and thus a
SECURITY subject to federal securities laws
i. Risk is NOT part of the Howey analysis
1. Even if promoter promises investors a fixed return (as opposed to a variable return)
b. Return on Investment (ROI) does not affect finding a security
c. NOTE – Court did not address “commonality” in Edwards. Circuit courts handle it different ways (See
Prong 2 below)
Howey Prong 1: Investment of Money
Use of term “stock” DOES NOT automatically mean securities laws will apply
a. MUST apply Howey / ECONOMIC REALITY (USE OR CONSUMPTION) TEST – 2 PRONGS:
1. What was the purchaser’s expectation/motivation? Was the purchaser being a capitalist? WAS
THERE AN INVESTMENT INTENT?
a. Is motivation USE or CONSUMPTION? If yes, no investment of money, not a security.
United Housing Foundation v. Forman (1975) (Powell)
Facts: Co-operative shareholders sued mgmt comp. under securities laws b/c they had “stock” in co-op.
Holding: Stock in subsidized nonprofit co-op is not a security, therefore securities laws do not apply
ii. MUST BE TRUE INTENT FOR A CAPITALISTIC TRANSACTION
NOTE: Absent here is an investment where one parts with his money in the hope of receiving profits from the
efforts of others. Here there was only a purchase of a commodity for personal consumption or living
quarters for personal use.
Takeaway--> Stock doesn’t always mean security
Economic reality test--> am I actually giving you capital? No, he simply bought an apartment
Hypo: Jaguar PAGE 40 (USE/ CONSUMPTION TEST IN ACTION)
Jaguar wants to sell car it is mfg. but needs to raise money.
Tells Group A, Jaguar lovers, “put in $80,000 today, wait 3 years, and pay remaining balance of $500,000 later
to receive car with projected market value of $1.6 million.”
4
Tells the same to Group B, Goldman Sachs customers, who don’t know a Jaguar from a Beetle. Investment?
Group A: No, Expectation is to use/consume (economic reality test), so fails first prong of Howey
Group B: Yes, Expectation is profit, not to use/consume the Jaguar
NOTE – It is the INTENT and MARKETING of the DISTRIBUTION STRATEGY that governs
2. Landreth Timber Co. v. Landreth (1985)
a. Facts: Family sold 100% interest in its lumber company. The purchaser sought rescission and damages.
b. Holding: Court said the stock was a security and declined to adhere to the Sale of Business Doctrine
i. Sale of Business Doctrine (OLD, prior to Landreth)
a. Prior: If you sold 100% of common stock to someone else, it was not a security because it
failed efforts of others prong (third prong) of the Howey Test.
ii. Here, the purchasers had no intention of running the lumber-sawmill themselves.
a. The stock was found to be stock that is expressly enumerated in Section 2(a)(1) of the ’33 Act
c. NOTE: The analysis here may NOT be applied to notes and similar instruments, so doesn’t mean that
just because it says it’s a stock, it is a stock (confuses most lawyers who haven’t taken this course):
“Instruments that bear both the name and all of the usual characteristics of stock seem to us to the
clearest case for coverage by the plain language of the definition”
9/11/17
Howey Prong 2: In a Common Enterprise
1. What is a “Common Enterprise?”
a. Circuit Split
i. Horizontal Commonality
ii. Vertical Commonality
2. Horizontal Commonality
a. All investors rise and fall together, have the same common fate, invest in the same enterprise
i. Just like Howey: Everyone’s oranges were mixed together
b. Problem: What if there is only one investor? Then there is no commonality
i. Judge Posner (SEC v. Lauer (7thC. 1995)): Horizontal Commonality can exist w/ just single investor.
1. Focus is not on the actual presence of investors, but that the character of investment would have
allowed multiple investors. If you could have sold to others and chose not to that would meet
the commonality requirement.
2. Otherwise, a defrauder content to defraud just one single investor would have immunity from
the securities laws
ii. BUT if investment is so unique as to be attractive to only one investor then NOT a security
1. Meets the uniqueness exception (but doesn’t fail Horizontal Commonality)
3. Vertical Commonality
a. Requires commonality between investor and the promoter (i.e. issuer).
i. Look at relationship between investors and manager.
b. Two Types:
i. Broad Vertical Commonality
1. Requires some nexus of interest between investor and manager
5
a. E.g. When investors make $, promoter makes $. When investors do not make $, promoter
does not make $ either, but manager does not lose $ even though the investors lost $.
b. Just like Howey
ii. Strict Vertical Commonality
1. Requires manager and investor to be equally at risk.
a. When company loses $, manager loses $
i. E.g. If Howey had not built cost of business into price of the K, he would have had to
pay out of pocket if business lost, so there would have been strict vertical commonality
Howey Prong 3: Success Depends on EFFORTS OF OTHERS
1. Not a strict test
a. So long as success depends predominantly on efforts of others, the prong is met.
Basically, it must be a passive investment
2. “Solely” has been written OUT of Howey Test
a. See SEC v. Koscot- Question is whether non-investor efforts are undeniably significant in affecting the
success / failure of the enterprise.
i. Efforts must occur AFTER the investment is made.
3. What about stock owned by a manager?
a. Hypo: Joe’s Autobody. Small business. Some stockholders, but Joe is the manager. Is Joe’s common
stock in the Autobody not a security because he himself is doing the work?
i. NO. Is it common stock, and the nature of the instrument does not give control.
4. General Partnership vs. Limited Partnerships
a. General Partnership- every partner has the right to manage and bind the partnership
i. General Partners each own a % of the business and all have legal right to bind the business. All
partners are 100% liable for the debts of the partnership.
1. GP interest is usually NOT a security because it fails the Third Prong of the Howey Test
a. Full and equal mgmt. rights for every partner
b. HOWEVER--->Miller v. Central Chinchilla: Foreman- economic reality (names don’t
matter); but if you have “general partners” that have no idea about the business, and have
no real control, relying on the operator STILL a security, meets third prong (efforts of
others) so sometimes, general partnerships can be considered a security.
b. Limited Partnership
i. Two classes of partners here: general partner and limited partners. General Partner manages
business; Limited Partners have no interest in management and are passive, just like corporate
stockholders
1. LP interest IS usually a security because it meets the Third Prong of the Howey Test and they
usually have to rely on the efforts of the general partners.
2. Unless- the limited partner has too much power to be deemed passive under Howey. so
sometimes, LP are not considered a security.
ii. FRANCHISE LAWs put in place due to Howey- Franchises: McDonald’s requires franchisees to be
owner-operators, thereby circumventing the “efforts of others” element of Howey. The level of
6
activity required of investors to ensure the success of the investment prevents them from being
classified as an investment K. BUT the economic reality is that the contribution of the franchisees
significantly and substantially affect the profits expected from the enterprise. Therefore, if it is
owner operated, then it is not a security because it does not meet the 3rd prong of Howey. However,
states have adopted franchisee laws which are similar to securities laws to protect franchize owners
from fraud.
5. Limited Liability Company (LLC)
a. Whether LLC membership interest is a security is ad hoc.
i. LLC is like a hybrid: limited liability of corp, pass-through tax treatment of partnership. Manager
manages and investors are members.
b. Must look at operating agreement and see how many management rights members have.
i. If they have a good amount of control over management, then NOT a security
c. Must also look to how relationship plays out in fact
i. If the operating agreement gives members control but members do not in fact have real control,
then the LLC interest IS a security
6. Corporations
a. State corporate law expressly provides that stockholders do not have management power.
i. By virtue of statutory definition, corporate stock IS a security
7. Timing Requirement
a. Efforts of others MUST COME AFTER investment
i. E.g. AIDs case.
1. Terminally ill person makes an investor his beneficiary in exchange for an immediate
discounted lump sum (I’ll give you $800K for your $1M policy, today). This is not an
investment contract and therefore NOT a security because at the time of the contract, “efforts of
others” was complete and investor just wanted policyholder to die.
ii. SEC v. Life Partners, Inc. (D.C. Cir. 1996)- aids case
1. Efforts of others need to occur after purchasers make their investments. D did nothing to create
wealth, waited for people to die.
2. Efforts of “Others” can’t refer to a 3rd party, must be the party the investor is dealing w/.
3. “Capital has to facilitate”
EXCEPTIONS (TO WHAT IS A SECURITY)
Uniqueness Exception
1. A business arrangement that is so unique as to be attractive to only one person on the planet is an
exception to the Howey Test for an investment contract. This kind of business arrangement is not a
security.
a. E.g. a neighboring farmer
2. Marine Bank v. Weaver (1982) (Burger)
7
a. Facts: Plaintiffs, neighboring farmers, acquired 50% interest in slaughterhouse profits and right to use
barn and pasture. Neighbor using each others barn
b. Holding: The “certificate deposits” were deemed NOT securities, even though Howey Test was met.
c. NOTE: Unfortunate language here: “Congress intended securities laws to go to those instruments
ordinarily considered . . .” and “this unique arrangement was not designed to be traded publicly”
i. Poor writing!!! These are not parts of the Howey Test
d. The only important takeaway is that this case represents a “uniqueness” exception to finding a security
Better Regulatory System Exception
If another agency more appropriately designed to regulate something is better suited to deal with a given
transaction, then the interest is NOT deemed a security. That trumps Howey and the SEC does NOT get
involved
a. Not always fool proof; should be judicious in this exception’s use
2. Teamsters v. Daniel (1979)
a. Pension plan at issue was deemed NOT a security even though the Howey Test was met because
ERISA (Employee Retirement Income Security Act) is specifically designed to deal with pensions under
federal law
3. Marine Bank v. Weaver (1982)
a. Court concluded that bank certificate deposit at issue was NOT a security in part because the holders of
the bank certificates of deposit are abundantly protected under federal banking laws
DEBT-LIKE SECURITIES: “FAMILY RESEMBLANCE” TEST
1. NOT every NOTE is a security (E.g. consumer note)
2. Note is a promise to pay money
There are 2 types of notes: Equity and Debt
1. Debt securities: E.g. Notes, Debentures, Bonds (diff bet. ea.: note- less than 3 yrs, debenture- 3-12 yrs
intermediate, bonds- long term, 12 yrs or more)ALL are securities
a. Despite plain language of § 2(a)(1), not all notes, debentures, and bonds are securities
i. E.g. Joe’s Autobody pledges accounts receivable to secure short-term note to bank in exchange for
payroll funds – NOT a security
2. Reves v. Ernst & Young (1990) (Marshall) – commercial notes (court made up) vs. investment notes
a. Holding: Commercial Notes are NOT securities, but Investment Notes ARE securities
b. To determine whether a note is commercial or investment in nature:
i. FAMILY RESEMBLANCE TEST (All 4 MUST be met)
1. Motivation of Parties
a. If commercial finance agreement Commercial
b. If investment arrangement Investment
8
2. Meant to be Traded/Plan of Distribution?
a. If cannot be traded Commercial
b. If can be traded Investment
3. Reasonable Expectations of the Public
a. If financial world would consider note commercial Commercial
b. If financial world would consider note investment Investment
4. Is another regulatory scheme better suited to deal with the instrument?
a. If yes Commercial
b. If no Investment
c. NOTE: 2d Cir. has presumption that any note w/ a term of more than 9 months is a security
i. Can be rebutted by issuer
AUTOMATIC APPLICATION OF SECURITIES LAWS (waiving)
1. ’33 Act § 14
a. “Any condition, stipulation, or provision binding any person acquiring any security to waive
compliance w/ any provision of this title or of the rules & regulations of the Commission shall be void”
2. CANNOT blankly opt-in, either; or elective, elect to waive
CANNOT PUT A CLAUSE IN A K THAT THIS IS NOT A SECUIRTY!!!!
SECURITIZATION
1. Any entity that issues securities is an issuer
2. Hypo: Scotch
a. Scotch Co. sets up trust. 100 people put in $1,000 each. Trust now has $100,000. Scotch Co. gives money
to distiller, who takes money and pays for labor + capital. $100,000 barrels of immature scotch go into
trust. After twelve years, distiller bottles and labels the scotch, and sells for $200,000.
i. This scotch is a security. Passes the Howey Test.
ii. When we turn a product like scotch into a security, it’s called a securitization.
1. Howey was securitization of oranges.
REAL ESTATE AS A SECURITY??
3. Hocking v. DuBois (9th Cir. 1989) (Goodwin)
a. Facts: Real estate agent persuaded person in Chicago to buy condo in Hawaii. Agent said she’d take
care of renting it, maintenance, etc. Made these contracts with a few investors.
b. Holding: Real estate contract IS a security. Meets all the tests of Howey. He was induced to buy this
to make money.
i. This is NOT real estate as a security; it is securitization of real estate, which makes the K a security.
ii. NOTE: Horizontal Commonality existed
iii. NOTE – Standard real estate transaction in form of sale or lease DOES NOT involve securities
c. Where was the control?
i. See Williamson v. Tucker (5th Cir. 1981)
1. Where the investor is a general partner or joint venturor, he must establish at least one:
a. 1. The agreement leaves little power in the hands of the investor (like limited partner)
9
b. 2. Investor is so inexperienced in the business that he is incapable of intelligently exercising
his powers
c. 3. Investor is so dependent on some unique managerial ability of promoter or manager that
he cannot replace the promoter or manager or otherwise exercise meaningful powers
OVERVIEW
● If an instrument says “stock,” there is a presumption that it is a security
● Default provision of a security = investment contract
● Partnership interests and LLCs are not defined so you apply Howey to them
● Once a security, always a security.
10
SECURITIES ACT of 1933
SECTION 5: DISCLOSURE!!! (‘33 act all about this, all else is commentary)
1. ’33 regulates PRIMARY and SECONDARY offerings of securities to the public.
a. Lots of distrust by ’32- law created that every time an issuer wants to raise capital (issue sec’s), must
provide investor w/ document w/ complete & total disclosure Section 5 requires FULL disclosure of
the good, bad, and the ugly created SEC
b. How to make Ma & Pa have faith in primary offerings
c. Section 5 ONLY APPLIES TO issuers, underwriters and dealers
d. Only filing a prospectus, not registering anything.
2. Primary Offering
a. Every time an issuer issues securities
i. Initial Public Offering (IPO): First primary offering
3. Secondary Offering
a. When non-issuer offers securities, by a person (trust, being, etc.)
i. E.g. Bill Gates selling his shares
4. Contra with Secondary Transactions (trading), Aftermarket
a. Buying and selling securities- NYSE/ NASDAQ
i. This is covered by the ’34 Act; nothing to do w/ ’33 Act
Terminology:
● Issuer- Any “person” (company, entity, enterprise; cf. individual) that issues securities (raise capital).
They sell securities to the public.
o An issueer cannot sell securities unless reg. statement is in effect (so even if they buy back and
want to sell, can’t b/c reg. statement –prospectus- dies in 9 months)
● Underwriter- An entity that buys the securities from the issuer and then sells them to a distribution
network (brokers). Underwriters are essentially the wholesalers of the securities industry.
● The Offer and Offering of Securities- Means just what it says, an offer to buy. There are several types.
Methods of Underwriting
● Firm Commitment - Goldman Sachs agrees to buy 1 million shares from Microsoft at $42/share. GS
owns them. Spills them out to the public and syndicates. Microsoft has the capital to operate.
● Best Efforts - GS says to Microsoft, “I’ll do my best to sell stock, but I’m not committing.” GS will only
take down what they have the market for. GS is only on the hook for what they can sell.
5. ‘33 Act is all about Section 5. Everything else is commentary.
a. § 5(c)
i. No one can offer to sell a security unless Registration Statement has been filed with the SEC
b. § 5(a)
i. No one can sell/deliver a security unless Registration Statement is in effect (must be currently
in effect if it was registered in 1997 it is NOT automatically in effect—that’s too old needs to be in
effect this year)
c. § 4(a)(1)
i. § 5 shall NOT apply to transactions by any person other than an issuer, underwriter, or dealer
11
ii. § 5 applies only to issuers, underwriters, and dealers
6. “Registration Statement” is a DISCLOSURE Statement (not actually reg’ing anything, only filing pros.)
(GIVING CURRENT DISCLOSURE IS THE MOST IMPORTANT PART)
a. Nothing gets registered; there is no registry! Actually preparing a disclosure statement
i. If the disclosure is inaccurate, go to jail CRIMINAL OFFENSE
b. Two Parts: (SEC oversees this)
i. Prospectus (most fundamental; if inaccurate, go to jail)
1. Any written communication that offers a security for sale.
a. Basically a sales brochure
b. SEC requires plain English. NY Times reading level (issuer counsel is in charge of drafting).
c. Risk factors, just be fully honest, and tell the story with accuracy
d. Statements last for 9 months
2. Anything that markets a product is a prospectus.
3. Just has to be HONEST, just disclose risks
ii. Ministerial Part
1. Supplemental information, signatures, and exhibits
7. SEC Forms for Registration
a. S-1 Default form
i. A series of questions that issuer must respond to in prose (plain language). Must disclose
everything investor needs to know, or should know.
b. S-2 Seasonal companies
c. S-3 Gigantic companies like Microsoft
d. S-4 Mergers
e. S-8 Options
8. How does Registration Work? (disclosure statement filing- must be filing and accurate)
a. 1. Issuer wants to sell stock to public. Counsel prepares prospectus using one of the forms listed above
i. Prefiling Period
b. 2. Issuer files registration statement with SEC in Washington, and the SEC reviews from two
perspectives Waiting Period
i. SEC’s perspective: To ensure, as a practical matter, that issuer has answered every question
ii. Investor’s perspective: To ensure registration statement makes sense
c. 3. SEC provides issuer with comments based on what it thinks reasonable investor would want to
know (this could happen several times)
d. 4. SEC, once a happy clam, declares registration statement “effective.”
i. Effective Period lasts for 9 MONTHS - then information and prospectus is deemed stale (issuer
cannot sell the stock any more even after a buy back) registration statement dies after 9
months!
ii. “Posteffective” Period
12
1. Issuer’s BOD meets & decides it
wants to raise capital by issuing
stock. Hires counsel to prepare RS
3. SEC declares RS "effective"
2. Issuer files RS w/SEC
1-2:
2-3:
3 till 9 mo.:
Prefiling period (“consistent period” begins)- in registration
“Waiting period” (comment period—back-and-forth w/SEC)
Posteffective period
Notes:
● Statutory Authority: SEC has no merit review authority: even though SEC signs off, it doesn’t mean
that SEC approves everything as correct. SEC can only require disclosure. Must print bold disclaimer
on cover – show that SEC reviewed it, but did not approve merits. In reality they have tremendous
discretion – SEC can issue stop order—must cease selling securities
● Timing: § 8(a): the SEC has 20 days to declare your registration statement effective
o This is a farce. Every time you file a registration statement, issuer makes voluntary amendment
waiving the 20 days for the SEC’s benefit. The quid pro quo is that when you are ready to go
effective, the SEC will allow the issuer to go effective on the time and date of his choosing.
● Discretion: Does SEC have right under statute to refuse to declare a registration statement effective?
o No, SEC cannot refuse to declare a reg. sttmt effective if you make proper disclosures. However,
SEC can get around by commenting a prospective issuer to death or by issuing a stop order.
▪ The process takes 6wks to 3mths depending on SEC’s workload.
●
●
Gun Jumping (pre-filing “offers” under §5)”: Efforts made to promote the sale of stock, even indirect
efforts to condition the market, prior to registration are deemed to be tantamount to making offers in
violation of §5. Permissible “gun jumping” guidelines change with each phase of the registration
process. Issue is how the SEC interprets the word “offer” under Section 5(c):
When are you in Registration? The time that you have to worry about gun jumping is when you are in
registration. Before you are in registration, you can do whatever you want.
o Conservative School of Thought: an issuer is “in registration” when senior management in has
made a good faith firm decision to proceed with a registration.
o Liberal School of Thought: an issuer is not “in registration” until a letter of intent has been
signed with an underwriter.
o No definitive SEC policy on this point.
The Pre-Filing Period (quiet period)- in registration
1. § 5(c)
a. Makes it unlawful to offer to sell a security unless the registration statement has been filed
b. Outlaws “gun-jumping”
i. No puffery, touting, etc.
13
c. Lobe, Rhoades: before filing the registration statement, LR was conditioning the market by puffing the
investment (this is great company). SEC filed an enforcement action and won. Conditioning the market
prior to the offering was a disguised offer, even though the security was never mentioned in LP’s
press releases, etc. and as such violated Section 5(c). This case gave rise to the concept of gun jumping.
d. Must be consistent- go about your business, advertise as you did, release news about new hires
2. § 2(a)(3)
a. “Offer” includes every attempt to dispose of a security
i. SEC considers activity that conditions the market to be an attempt to dispose of a security
1. E.g. Issuer cannot launch new PR campaign; it will be viewed as conditioning the market and
therefore an attempt to dispose of a security
3. 30-Day Bright-Line Exclusion
a. Rule 163A – ALL issuers have bright-line time period, ending 30 days prior to the filing of a
registration statement, during which the issuer or its agents can communicate
i. Requirements
1. Cannot make any reference to the securities offering
2. Communication may be by or on behalf of the issuer
4. EXCEPTIONS (PERMISSIBLE COMMUNICATIONS)- Safe Harbor
a. RULE 135 – Notice of Proposed Registered Offerings (For pre-filing and waiting period)
i. Safe Harbor. If issuer says certain things, and only certain things, those things will be deemed NOT
to be an offer once in registration
1. Can disclose intent to make a public offering: info about amount and type of security, and
manner and purpose of the offering
2. Once deemed NOT an offer, out of section 5
ii. Notice MUST CONTAIN:
1. Legend (mandatory) Statement that: “this notice does not constitute an offer for sale”
2. Limited Content (permissive) Issuer’s name; title, amount, and basic terms of securities
offered; amount of offering; anticipated timing; brief statement of manner of and purpose for
offering; whether offering is restricted to particular class(es) of purchasers
a. CANNOT (prohibited) name underwriters or the offering’s proposed price
b. § 2(a)(3) – Arrangements with and Among Underwriters (okay to announce intent to make pub. Offer)
i. Excludes from definitions of “sale,” “offer to sell,” and “offer to buy” both negotiations and
agreements that issuers have with their underwriters, as well as negotiations and arrangements
among the underwriters, provided they are or will become parties to the underwriting agreement
with the issuer
1. So issuer can talk with underwriter about the offer if the underwriter is or is to become in
privity of contract with the issuer
c. Communications with Qualified Institutional Buyers (QIBs) and Accredited Institutional Investors
i. § 5(d) of the ’33 Act as amended by JOBS Act
1. Permits “emerging growth companies” prior to (or after) filing a registration statement to
communicate with QIBs or accredited institutional investors to determine whether such
investors may have an interest in the security to be offered or being offered
14
d. Rule 169 – Factual Information (for NON-REPORTING issuers ONLY)
i. Non-reporting issuers have limited safe harbor for their communication of “regularly released”
factual business information
1. Protected ONLY IF audience is not investors, but others like customers and suppliers
The Waiting Period
1. Rule 430 - The Preliminary Prospectus
a. Upon filing, issuer has a preliminary prospectus with a red label that say “this is a PRELIMINARY
PROSPECTUS” (red herring necessary)
i. The “Red Herring” Red font on the front that state the communication was not an offer to sell,
that the security was not registered, and that no sales could occur until registration is effective
ii. Soliciting indications of interests is not an offer b/c gathering interest marks
2. § 5(b)(1)
a. Issuer CANNOT transmit anything in writing other than the preliminary prospectus
i. EXCEPTION
1. Tombstone Ads
a. Allowed under § 2(a)(10)(b):
i. A writing will not be deemed a prospectus if it states (1) where to obtain the preliminary
prospectus; (2) identify the security; (3) state the price; and (4) state by whom the orders
will be executed
3. Rule 433 - FREE WRITING
a. Supplementary info generally not found in the registration statement (e.g. a “term sheet”)
b. Rule 433 – Unseasoned Issuers
i. E.g. firm that is neither a “well-known seasoned issuer” nor one that is eligible to use Form S-3
1. Includes non-reporting companies AND reporting companies that use Form S-1
c. Can commence if registration statement has been filed and the free writing is accompanied or
proceeded by a prospectus that satisfies § 10 AND if it includes the security’s price range
4. MUST include legend setting forth where prospectus can be obtained through toll-free number AND SEC
website
a. Rule 433(b)(2)(i) – active hyperlink to most recent Prospectus meets the prospectus delivery
requirement
5. Issuer CANNOT make offers; can only gather “indicia of interest”
6. Issuer CAN make oral statements so long as they don’t create a binding oral K of sale ((want to buy? Yes 
5(a))
The Posteffective Period
1. Now issuer can start offering and selling the security
15
2. NOTE: § 5(b)(1) continues to prohibit written communications about the security unless the
communications take the form of a preliminary prospectus of the final prospectus
3. Get to fill in the pricing now (only real change)
a. EXCEPTION
i. If a communication is sent after the registration statement becomes effective, then a free writing is
deemed NOT a prospectus ONLY IF preceded or accompanied by a § 10 prospectus
4. § 5(b)(2)
a. Requires that any sale is preceded or accompanied by a Final Prospectus
i. It latest preliminary prospectus basically looks identical to the final prospectus and issuer calls
investor to ask if he is still interested, and investor says yes, this creates a contract of sale on the
spot
5. Rule 172- Final Prospectus
a. Rule 172(a) Exempts from § 5(b)(1) written confirmations
i. Absent this exception, a written confirmation would have to be accompanied by a final prospectus
b. Rule 172(b) Relaxes prospectus delivery requirements when the registered securities are to be
transferred
Action
Oral Statements
Written
Communication
Prefiling Period
--Prohibited
“Consistent Period” – continue
business as normal
Offer
Prohibited
Notice – Rule 135 UW
negotiating § 2(a)(10)
Emerging Growth Co. - § 5(d)
Prohibited
Sale
Waiting Period
OK – not oral binding
Preliminary Prospectus
Only
Tombstone Ads § 2(a)(10(b);
Free Writing
OK if accompanied by
preliminary prospectus
and no other writing
Prohibited
9/18/17
16
Posteffective Period
OK
OK if accompanied or
preceded by Final
Prospectus
§ 2(a)(10)(a)
OK if accompanied by
Final Prospectus
OK if preceded or
accompanied by Final
Prospectus or Final
Preliminary Prospectus
that is basically the same
MATERIALITY
1. Standard
a. Materiality Standard (objective)
i. Can SELL if final preliminary is same as the final prospectus
ii. A FACT IS MATERIAL if there is a substantial likelihood that a reasonable investor would
consider it important in deciding whether to invest (TSC Indus., Inc. v. Northway, Inc. (1976)
1. NOT subject to subjective/idiosyncratic beliefs of single investor
iii. Rule of Thumb: 5% (NOT a bright-line rule)
1. A misstatement regarding a financial statement item of 5% or less is not material
a. But the SEC Bulletin No. 99 (1999) rejected this approach
iv. Reasonable Investor?
1. Objective, not subjective. Mixed question of law and fact
a. E.g. Investor with particular sensitivity to dyed flowers sues florist for misleading
statement, representing purity of flowers. Investor would likely fail materiality (reasonable
investor wouldn’t care; it’s not about YOU)
b. Securities laws do not care about immaterial statements. So MATERIALITY is the drafting standard
i. E.g. Form S-1 asks about how old directors. Jalil, age 69, lists age as 64. Material?
1. No, although false. Not material. Jalil is still an old man.
ii. E.g. Same form. MIT grad, age 22, lists age as 49. Unlawful?
1. Yes. Misleading statement of material fact because of substantial likelihood reasonable investor
would consider it important in deciding whether to invest
iii. Statement that the UN estimates that the demand in china for phones will be 1 billion
1. Yes. Misleading, b/c you don’t have access to that market and or meet that demand
iv. Clothing manufacturer employs child laborers in Guatemala; .001% of revenue from the factory
1. One school of thought: 5% test should enter analysis. Since pornography contributes to 0.01%
total revenue, not material to a reasonable investor. No need to disclose.
2. Another school of thought: It could be material to a reasonable investor. Must disclose.
c. Omissions – army contract, but omit that they’re cancelling the K misleading
d. MAY differ on the result, but the approach is: would a reasonable investor find this material?
2. Buried Disclosure Doctrine
i. A buried disclosure is no disclosure at all
1. E.g. Cannot bury news that government cancelled contracts with issuer in footnote on p. 79 of
the prospectus MATERIAL
ii. Must give prominence to the most material information
1. In BOTH expression and position (context & visual)
3. When Dealings are Face-to-Face
a. Thomas v. Duralite Co., Inc. (3d Cir. 1975)
i. Standard is still objective materiality, even where the subject transaction involves a single seller and
single buyer, each well known to the other, and the distinction between objective materiality and
subjective reliance becomes obscured
4. Prospective/Speculative Information (future events)
a. Apply PROBABILITY/MAGNITUDE TEST
17
i.
Balances the probability of something happening with magnitude of its impact
1. On a scale of 1-100, what’s the probability of the projection coming true?
2. On a sale of 1-100, what’s the magnitude of the projection coming true?
3. ADD the numbers, and if they tip a certain level (e.g. 125), then Disclose
b. Theory: Whether the information is material depends on the significance the reasonable investor would
place on the withheld or misrepresented information
c. NOTE: CEO cannot decline to disclose prospective information on grounds that he has a fiduciary
obligation to shareholders and that disclosure would harm shareholder value
i. MUST disclose good, bad, and ugly
d. See Basic v. Levinson (1988)
i. Holding: Total Mix standard for disclosing speculative information
Event
Looking at 125 line
Playing golf with Bill Gates, and he says: “maybe I’ll buy
your company
VP of acquisition of Microsoft calls and asks for info for
potential acquisition
President gets call from Goldman Sachs, stating Microsoft
wants to buy and they want more info, asking for what
would be a meaningful price.
Probability
in Reality
Magnitude
Sum
Disclose?
10
100
110
No
20
100
120
No
130
Yes. So say co was
approach by MSFT
re acquisition. No
assurance can be
made.
30
100
5. Truth on the Market / Market Efficiency
a. See Wieglos v. Commonwealth Edison Co. (7th Cir. 1989)
i. Prompt incorporation of news into stock price is the foundation for Fraud-On-The-Market claims
and therefore also supports Truth-On-The-Market
PRIMARY OFFERING EXEMPTIONS (exempt from Section 5)
1. § 3 Generally exempted Securities- May be resold free of disclosure burden
2. § 4 Generally exempt Transactions- Cannot be resold unless issuer files registration statement with SEC
under § 5 or another exemption is available
a. Securities sold under transaction exemption do not automatically become exempt.
b. Each time such securities are transacted, seller must find a transaction exemption to avoid filing Reg
Stmt w/ SEC. If not, issuer must filed RS
3. NOTE: ’33 Act contains some drafting errors, whereby certain exempted Transactions are in § 3
a. E.g. § 3(a)(11) – Intrastate offering exemption, which is an exempted Transaction
Introduction to Exceptions:
§2(a)(3): Underwriter Negotiations Permitted - One major exception to the definition of “offer” permits an agreement
between the underwriter and the issuer (or between underwriters) so that they may reach agreement before registration
without violating the securities laws.
18
§ 4(a)(1): registration requirements of § 5 do not apply to transaction by persons other than an issuer, underwriter, or
dealer with respect to that offering. § 5 does NOT apply to secondary trading, but DOES apply to secondary offerings
(someone other than the issuer like an underwriter). Second five only applies to issuers
§ 4(a)(2): the registration requirements of § 5 DO NOT apply to transactions by an issuer not involving a public offering
(non-public offering = private placement).
§ 3 (Exempted Securities—drafting error): covers 2 major categories: (i) exempt securities (US treasury bonds, e.g.) and
(ii) certain exempt transactions (these say that if you sell a security this way, that particular offering is exempt—ex:
3(a)(11). (exempted securities are also called exempt offering – if you follow the preceptf o section 3(a)11 your offering
will be exempt from section 5)
§ 4(a)(1) – Transactions By Any Person Other Than An Issuer, Underwriter, or Dealer
1. § 2(a)(4)
a. Defines ISSUER to mean every person who issues or proposes to issue any security
2. § 2(a)(11)
a. Defines UNDERWRITER to mean every person who has purchased a security from an issuer with a
view to distribute to the public
3. § 2(a)(12)
a. Defines DEALER to include broker
SEC Rule 147 Safe Harbor – Exemption for Intrastate Offers and Sales of Securities
1. In-State Issuer
a. For purposes of § 3(a)(11), issuer shall be deemed to be a resident of a state if it is incorporated in or
organized under the law of that state
b. For purposes of § 3(a)(11), issuer shall be deemed to be doing business within such state if it
i. Has principal place of business (HQ) in such state;
ii. Derives 80% of its gross revenues within such state;
iii. Has 80% of its assets located within such state; AND
iv. Intends to use at least 80% of the net proceeds from the offering within such state
c. NOTE: AS AMENDED
i. Triple 80% Test IS NOW “OR”
1. Need only 1 of them
(no requirement for disclosure)
Investor cannot resale out of a state in six months
2. In-State Investor
a. Individual’s in-state residence can be established by actual principal residence
b. Business entity’s in-state residence can be established by principal office
c. Investors can resell out-of-state after *6months
i. This is not a holding period – investor can resell to another in-state investor because the SEC
cannot regulate that purely intrastate transaction.
ii. Escrow
1. To protect itself, issuer sells security to investor subject to requirement that security is held in
issuer’s escrow for investor’s account for 9 (or 6, as amended) months
19
iii. Legend
1. Issuer should put a legend on the stock certificates
d. Very Limited Exception
i. If investor moves and, at the time of sale, issuer and investor, in good faith, did not know investor
would move, SEC grants issuer a pass.
3. Integration Doctrine
a. SEC may treat intrastate offering as part of a larger offering to out-of-state investors under integration
doctrine
b. 6 Month Safe Harbor
i. Offers and sales made more than 6 months before intrastate offerings and later than 6 months after
intrastate offerings are not integrated with intrastate offering
4. NO DISCLOSURE REQUIRMENT
●
●
INTEGRATION DOCTRINE
Under the doctrine of integration, the SEC will COMBINE separate offerings (e.g. intrastate offerings
done in different states) and treat them as ONE offering if certain factors are present (when an
offering is integrated with another offering, the exemption may be blown)
Integration “prevents an issuer from improperly avoiding registration by artificially dividing a single
offering [so that] exemptions appear to apply to the individual parts where none would be available to
the whole.” Whether to integrate “calls for an analysis of the specific facts and circumstances” [SEC
Rule 155 Release]
1. SEC applies 5-Factor Test
a. NOTE: No one test is bright-line or dispositive)
i. 1. Are the offerings part of a single plan of financing?
1. If yes favors integration
ii. 2. Offerings involve same class of securities?
1. If yes favors integration
iii. 3. Offerings made at or about the same time?
1. If yes favors integration
iv. 4. Same consideration received for each offering?
1. If yes favors integration
v. 5. Offerings made for same general purpose?
1. If yes favors integration
2. In effect, SEC is looking to see if the offerings constituted one big financing
20
SEC Rule 147A Safe Harbor
1. New Rule; won’t be effective for 6 months
2. NOT a § 3(a)(11) exemption
3. An issuer may do an intrastate offering in the state where it’s incorporated OR where it has its principal
place of business
a. Still needs to be offered only to in-state residents, however
§ 4(a)(2) – The Private Offering EXEMPTION 9/18/17
1. § 4(a)(2) offerings are “NONPUBLIC OFFERINGS”
a. “Private placement” is a misnomer because it connotes a cap on investors, which is not the case
i. E.g. I can sell to 10,000 business school professors under § 4(a)(2), but if I sell to 1 kindergarten
teacher (financially unsophisticated), then it’s a public offering
ii. Vast majority of securities placements are under Ralston Purina
Section 5 does ont apply to transactions by an issuer not involving any public offerings
2. Four Factors of Importance (Although the focus of the inquiry has shifted since Ralston Purina):
a. 1. The number of offerees and their relationship to each other and to the issuer
i. Substantial number of offerrees public in nature
ii. If offerees are members of a class having special knowledge of issuer private offering is
strengthened
b. 2. The number of units offered
i. Issuance of small number of units in large denominations is evidence of private offering
c. 3. Size of the offering
i. Exemption is intended to apply to small offerings
d. 4. Manner of Offering
i. Transactions through direct negotiations are more likely to be private offerings
3. SEC v. Ralston Purina Co. (1953) (Clark) (THIS and Howey V. important)
a. Facts: Ralston Purina decided to offer common stock to employees. It sold stock to hundreds of
employees including clerical and janitorial staff. Employees lived all over the U.S. Ralston Purina did
not file a registration statement. Just like in Howey, the employee-investors were happy as clams.
b. Issue: Whether Ralston Purina unlawfully sold securities to employees in violation of § 5
i. SEC’s Argument: 35 or more investors is a public offering
ii. Ralston Purina’s Argument: 35 is nowhere in the statute. Offering was nonpublic because it was
made only to employees
c. Holding: Both SEC and Ralston Purina are wrong (RS still guilty)
d. Rule: “Public” is a noun, not an adjective.
i. § 4(a)(2) should be read so that it exempts transactions by an issuer not involving an offering to the
PUBLIC guilty
1. Public = anyone who needs protections of the ’33 Act; anyone who cannot fend for himself, is
not financially sophisticated
e. Significance: Created 2 classes of investors
i. Financially sophisticated (e.g. not the public)
21
ii. Financially unsophisticated (“the public”)
f. BIG TAKEAWAY
i. An offering to financially unsophisticated persons requires § 5 disclosure
ii. An offering to financially sophisticated persons does not require § 5 disclosure
1. THERE IS NO “PRIVATE OR PUBLIC”
2. Nothing to do with numbers, nothing to do with private, has to do with financial sophistication
a. Example: 10,000 grad students financially literate = private 1 kindergarten teacher not
financially literate = public ONLY HAS TO DO WITH QUALITY OF THE INVESTOR
4. THREE REQUIREMENTS of § 4(a)(2)
a. 1. Financially sophisticated investors
i. Question of fact
1. What’s your investing history?
2. Do you manage a portfolio?
3. Can you read a balance sheet? Income Statement?
b. 2. No general solicitation
i. Cannot have even one financially unsophisticated offeree
ii. Placement Agents: Issuer CAN rely on underwriter to select financially sophisticated offerees
1. E.g. Goldman Sachs clients Goldman in trouble
c. 3. Information (Disclosure or Effective Access)
i. Financial sophistication is irrelevant if investors lack disclosures/access to information to which to
apply their financial sophistication
1. Two ways to satisfy: (Given or have access to info)
a. Disclosure through a Private Placement Memorandum (PPM)
i. Does not have to contain all of the info that goes into § 5 prospectus
b. Effective Access
i. No disclosure or PPM necessary if investors have access to relevant information
1. E.g. Bill Gates. He doesn’t need a PPM from Microsoft (insider)
ii. So, sophistication does not eliminate the need for information
§ 3(b)(1) – Small Issues Exemptive Authority
1. § 3(b)(1) authorizes the SEC to issue rules exempting from § 5 any offering of $5,000,000 or less
a. SEC enacted a series of related rules known as “Reg D,” which does Double Duty (both an exercise of
planary authority in 3b1 and 4a2)“Private Placement Exception” (501-508)
b. A Regulation= a series of related rules
i. Rules 504 and 505 (NOTE: As amended, 505 is gone) authorized under § 3(a)(1)
ii. Rule 506 is authorized under § 4(a)(2)
1. No monetary limit on offering, but cannot be to the “public”
2. Most offerings are done under Reg D- it is permissible not mandatory
iii. Require no filings
c. SEC also enacted “Reg A”
i. Rules 251-264 exempt offerings to public that don’t exceed $5,000,000 within 12-month period
ii. Requires a short filing on Form 1-A, which led to Reg A’s nickname “mini-registration”
22
1. Bad nickname because it is inaccurate; registration evokes § 5
2. ALL § 3(b) offerings are subject to 12 month aggregation rule, but Reg A offerings only aggregate with
other Reg A offerings
9/25/17
Regulation D
1. SEC Rules 501-508
2. Applies to Primary Offerings ONLY
3. All about clarity and bright lines
4. Rule 501 – Definitions and Terms (def’s can only be used when offering under Reg D, not 4(a)(2))
a. “Accredited Investor” – for purposes of Reg D, means:
i. A bank, insurance company or registered investment company;
ii. A corporation with assets exceeding $5,000,000;
iii. A director, executive officer, or general partner of an issuer;
iv. A natural person who has individual net worth, or joint net worth with spouse, that exceeds
$1,000,000 (excluding value of primary residence)
v. A natural person with income exceeding $200,000 in each of the 2 most recent years or joint income
with spouse exceeding $300,000 for those years
1. All presumed to be fin. sophisticated (arbitrary bright line), BUT “Wealthy moron” problem
a. Unsophisticated kindergarten teacher wins lotto.
i. NOT financially sophisticated for purposes of § 4(a)(2) offering
ii. BUT deemed an accredited investor under Reg D
Regulation is a series of related rules that work together
5. Rule 502 – General Conditions
a. Integration (Safe Harbor)
i. 6-month safe harbor
1. Offers and sales of securities more than 6 months before or 6 months after Reg D offering will
NOT be considered part of Reg D offering. But offers in that time frame will be integrated in.
a. E.g. If issuer completed § 5 offering 3 months before or after Reg D offering, SEC could
integrate the offerings and argue that the Reg D issuance violates § 5
b. Disclosure
i. Required under Rules 505 and 506(b) only
ii. Disclosure must be given a reasonable time prior to sale
iii. If an issuer sells securities to any purchaser that is NOT an accredited investor, it must give certain
disclosures
1. In non-accredited investor disclosure needed
2. If accredited investor no disclosure needed
c. No General Solicitation
i. For Rules 504, 505, and 506(b) ONLY
23
ii. Need a connection between issuer and investor so that, prior to the offering, issuer has a basis for
believing that investor is financially sophisticated; no tv/ radio
1. Issuer can rely on Placement Agents
d. Resale is Restricted- the Reg D securities cant be resold the next day
6. Rule 503 –Form D
a. Issuer offering/selling securities under Rules 504, 505, or 506 MUST file Form D
i. Within 15 calendar days must file form after FIRST sale
RULE 504 – Exemption for limited offers/sales of securities not exceeding $5,000,000
1. NOT AVAILABLE to issuers that are REPORTING COMPANIES or INVESTMENT COMPANIES (e.g.
Fidelity, Oppenheimer), really for small companies
2. Conditions
a. MUST comply with Rules 501 and 502(a), (c), and (d)
i. Therefore, Rule 504 offers require NO DISCLOSURE (regardless of offeree)
b. Aggregate Offering Price
i. Must be $5,000,000 or less within previous 12-month period (can’t have mult. offerings)
1. All of this was to encourage new businesses to spawn
REPEALED RULE 505 – Exemption for limited offers/sales of securities not exceeding $5,000,000
1. NOT AVAILABLE to issuers that are INVESMENT COMPANIES
a. Unlike Rule 504, reporting companies can use Rule 505
2. Conditions
a. Must comply with Rules 501 and 502
b. Aggregate offering price under § 3(b) must be $5,000,000 or less within previous 12-month period
c. No more than 35 purchasers of securities allowed to participate in offering
i. BUT Rule 501 says “Accredited Investors” do not count towards the total
3. *NOTE – RULE 505 does not exist as of mid-2017
Rule 506 – Exemption for limited offers/sale WITHOUT regard to monetary amount of offering
4(a)2 is the safe harbor of 506 ---- who can do a 506? ANYBODY
1. Offers/sales that meet requirements in (b) shall be deemed exempt under § 4(a)(2)
2. Safe Harbor to validate that Issuer has made a valid 4(a)(2) (private offering)
3. Advantage – Securities issued under 506 are “covered securities” under the National Securities Markets
Improvement Act of 1996
a. Not subject to state regulation through registration, UNLIKE Rule 504
4. (b) Conditions:
a. Must comply with Rules 501 and 502
b. No more than 35 non-accredited purchasers of securities allowed to participate in offering
i. BUT Rule 501 says “Accredited Investors” do not count towards the total
ii. HOWEVER, non-accredited investors MUST BE FINANCIALLY SOPHISTICATED
1. See Ralston Purina
2. Can have any number of accredited investors: 2k, 5k
3. Issuer may rely on representations by investor or purchase representative
4. NO monetary limit (can raise $18M, $100M if wanted)
24
5. Addition: Rule 506(c)
a. Provides issuers an alternative way to do Rule 506 offering (as opposed to 506b)
i. Issuer MAY GENERALLY SOLICIT (using newspaper, internet advertising, etc.) so long as TWO
requirements are met: (industry is cautious now)
1. All purchasers are Accredited Investors
2. Issuer must take reasonable steps to verify that all purchasers are Accredited Investors
a. Whereas Rule 506(b) allows issuer to take Accredited Investor’s word
b. Issuers who have criminal convictions cannot take advantage of this offering
504
($5,000,000 limit)
Integration safe harbor;
No general solicitation;
Restriction on resale
505
($5,000,000 limit)
Traditional 506(b)
(no $ limit)
Integration safe harbor;
Disclosure to non-AIs;
No general solicitation;
Restriction on resale;
Integration safe harbor;
Disclosure to non-AIs;
No general solicitation;
Restriction on resale;
No more than 35 non-AIs
New 506(c)
(no $ limit)
Integration safe harbor;
Restriction on resale;
General Solicitation
allowed so long as all
purchasers are AIs and
issuer takes reasonable
steps to verify AIs
No more than 35 nonAIs;
Non-AIs must be
financially sophisticated
If something insignificant happens, Rule 508 may provide leniency
Special note about Rule 506 securities: They are covered securities under NSMIA and therefore preferable
6. Rule 507 – Bad Boy/Girl Provision
a. Issuers found to have violated Rule 503 are disqualified from exemptions under Rules 504, 505, and 506
7. Rule 508 – Insignificant Deviations from Reg. D
a. Insignificant deviations, when made in good faith and with reasonable effort to comply, will not blow
the exemption from §5 – SEC doesn’t like 506(c)
b. Violation of the rule against general solicitation is deemed significant
8. FINRA Rule 5123
a. Requires members to file with FINRA certain offering documents used in private placements or notify
FINRA if no such documents were used
i. Must occur within 15 days of sale
ii. Applicable beyond Regulation D offerings
§ 3(a)(11) Intrastate Offering Exemption
1. Exempts from disclosure for purely intrastate offerings (for the small Joe’s auto body shop)
a. Offerings by in-state issuer to in-state residents
i. NOTE: Exempts the offering, NOT the security itself.
2. Requirements (SEC doesn’t like 3a11)
25
a. (1) ALL offerees and buyers must be residents of 1 state (offered and sold)
b. (2) Issuer must be domiciled within such state & doing business within such state
NOTE – Relaxed req. pursuant to Rule 147A in 2017- SAFE HARBOR to structure 3(a)(11): offers and sales are
made only to persons resident w/in same state that the issuer is resident and doing business in
● (1) Deemed to be resident & doing business – state where incorporated and is principle place of business
● (2) Reqs: Derives 80% of revenue, 80% of assets, 80% of proceeds, or majority of employees in that state
3. No Limit on amount of money that can be raised, how often exemption can be used
4. Sophistication of offerees and investors does not matter
5. Security must “come to rest” in investor’s hands before he can resell out-of-state without being deemed
an underwriter (6 MONTHS): If the security does not come to rest, the exemption will be blown
6. Cautious about advertising- can’t make an offer outside the state, so that’s why no general solicitation
§ 3(b)(2) – Additional Issues Exemption
1. Added by JOBS Act of 2012 – exempt from §5
a. Only Rule enacted under § 3(b)(2) is Regulation A (below)
b. Congress thought $5M limit was too small, so instead of amending 3(b)(1), created 3(b)(2) under
plenary auth. of SEC (any rules)
c. Conditions
i. Aggregate offering amount does not exceed $50,000,000 in previous 12-month period
ii. Securities may be offered and sold to the PUBLIC
iii. Need a short form registration
iv. Securities shall NOT be restricted securities
1. No resale restriction
v. Civil liability provision in § 12(a)(2) shall apply to any person offering/selling
vi. Issuer MAY solicit interest prior to filing
1. Allows gun-jumping
vii. SEC shall require issuer to file audited financial statements annually
1. So there MUST be audited financials
a. This is the disclosure piece of the puzzle
viii.
Such other terms the SEC may require
Regulation A (“mini-registration”)
1. SEC Rules 251-264
2. Exemption for offerings to the public not exceeding $50,000,000 in previous 12-month period
3. Rule 252 – Offering Circular
a. Requires Short Form 1-A Must file with SEC
i. Gets “Light-Touch Review”
4. Reg A securities are NOT RESTRICTED- Can be resold at any time w/o seller being considered an
underwriter
26
5. Rule 254 – Testing the Waters (GENERAL SOLICITATION)
a. Issuers may solicit interest from prospective investors prior to filing Offering Statements
i. Must be filed with SEC before use
b. NOTE – If the issuer changes course after “Testing the Waters” and decides to register under § 5
instead, the offering will not be integrated with the registered offering IF AT LEAST 30 DAYS have
elapsed between last solicitation of the Reg A offering and the filing of the Registration Statement
6. Rule 262
a. Bad Actor Rule – If the issuer or those closely associated with issuer have engaged in misconduct, the
issuer is disqualified from doing Reg A offering
7. REQUIREMENTS
a. Issuer
i. U.S. or Canada-based;
ii. Non-reporting company;
iii. Not an investment company
b. Bifurcation of Issuer
i. Tier 1 Up to $20 million during any 12 mo period
ii. Tier 2 Up to $50 million (must put legend and securities can’t come back to US for 40 days)
iii. Tier 3 – legends, and securities cant come back for 1 year
8. Aggregate Offering Price cannot exceed $50,000,000
a. Look back 12 months and verify that aggregate Reg A offerings only do not exceed $50,000,000
i. E.g. On July 1, issuer wants to do a Reg A offering. Must look back 12 months. Did a Reg A offering
on May 1 for $20,000,000. Therefore, issuer can only do a $30,000,000 max Reg A offering
b. Only aggregates with other Reg A offerings
9. Integration with other offerings - Rule 251(c)
a. Offers and sales under Reg A shall NOT be integrated with
i. ANY prior offers or sales of securities; or
ii. Subsequent offers or sales of securities that are:
1. Made under § 5;
2. Made in reliance on Reg S; or
3. Made more than 6 months after the Reg A offering
10. Securities LAWS only applies to offers and sales “within the US”; any offering made by any non-US
company to target any US group (military in Afghan, consulate), SEC will assert jurisdiction
Regulation S- offer of sale of securities will be deemed OUTSIDE the US jursidiction if:
i. (1) Off shore transaction (anything o/s US- Canada, Mexico)
ii. (2) No directed selling efforts in the US
1. The buy order must originate outside the US
2. Directed selling efforts = conditioning market to sell in the US, meet people in US etc. and then
step out of US
Regulation S
27
International Public Offerings
1. SEC Rules 901-905
a. Adopted in 1990; Provides safe harbors for offshore offerings of securities of U.S. and foreign issuers
2. Rule 500(g)
a. Securities offered and sold outside the US in accordance with Reg S need not comply with § 5 even if
the offshore offering is coincident with a domestic Reg D offering
3. Rule 901
a. For purposes of § 5, offers shall be deemed to include offers and sale that occur within the US and shall
not include offers and sales that “occur outside the US”
4. Integration
a. Offshore transactions made in compliance with Regulation S will NOT be integrated with § 5 offerings
OR exempted offerings
5. Rule 903
a. An offer of sale of securities will be deemed to have “occurred outside the US” if:
i. Offshore Transaction + No directed selling efforts made in US + Additional Conditions are met:
1. Offshore Transaction: Rule 902(h)
a. An offer is made in an “offshore transaction” if
i. Buy order originates o/s US (or seller reasonably believes buyer is o/s US) OR
ii. Transaction is executing on trading floor of a foreign exchange
1. E.g. If buyer was in US on 2-day visa and made purchase call from Florida, then
NOT an offshore transaction
2. No Directed Selling Efforts: Rule 902(b)
a. Any activity that could be considered conditioning the US market for offering of securities
in reliance on Reg S
i. Includes placing ad in publication q/ general circulation in US that refers to the offering
1. General Circulation: Any publication that is either (1) printed primarily for
distribution in US, OR (2) has 15,000 or more subscribers in US
3. Additional Conditions: Rule 903(b)(1), (2) and (3)
b. Rules 903(b)(1), (2), and (3) Divide world into THREE kinds of issuers, based on risk of flowback
6. Rule 904 Safe Harbor
a. Available for the resale of any security regardless of whether it was acquired in offshore transaction
under Regulation S
i. BUT CANNOT resell to anyone who is a US Person
7. Rule 135E
a. Not an offer to sell securities if foreign issuer permits journalists to attend press conferences or
meetings where information related to the proposed offering will be released
i. Conference/meeting MUST be held o/s US
8. SEC Release 7516 - Posting/Advertising on Internet
28
a. 1998 SEC Interpretive Release discusses when internet advertising will not be considered as taking
place in US:
i. Posting info on a website, anywhere in the world, MAY constitute an offering within the US
ii. However, SEC will NOT consider issuer as making offers to US Persons where issuer takes
precautionary measures reasonably designed to ensure offshore offers do not target US market
1. Prominent website disclaimer stating that offer is not intended for US
2. Requiring mailing address info or telephone area codes and numbers prior to the sale
b. Offshore Offerings by US Issuers
i. Additional precautions
1. Password Protection REQUIREMENT
a. Ensures only non-US persons can obtain access to the offer
Special Note on § 3(b) Transactions
1. Aggregation
a. Any time you have a § 3(b) transaction, look back 12 months and make sure it does not aggregate to
exceed the offering amount
i. Exception: Reg As only aggregate with other Reg As
1. So, if issuer wants to do a Reg A and a 504, the issuer should do the 504 FIRST and then do the
Reg A offering.
2. Integration
a. Any time you have offerings not involving Reg A, look for whether they can be integrated
i. Exception: Reg As do not integrate with any prior offerings
1. Reg As only integrate with subsequent offerings unless they are under § 5, Reg S, or within 6
months after
29
§ 4(a)(6) – Crowdfunding Exemption
1. CROWDFUNDING
a. Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure
i. The collective effort of a large number of individuals who pool their resources to support a third
party’s effort to achieve a stated goal or to engage in defined activity
2. § 4(a)(6) says § 5 shall not apply to transactions involving offer/sale of securities provided that:
a. Aggregate amount sold during 12-month period cannot exceed $1,000,000;
b. If purchaser’s annual income or net worth is less than $100,000, the aggregate amount sold to the
purchaser during any 12-month period cannot exceed the greater of $2,000 of 5% of the purchaser’s
annual income or net worth;
c. If the purchaser’s annual income or net worth exceeds $100,000, the limitation is 10% of annual income
or net worth;
d. Transaction must be conducted through a broker or funding portal registered with the SEC
3. NOT AVAILABLE for Reporting Companies under the ’34 Act
Rule 903(b)(1)
1. Least risk of flowback
2. Issuer
a. Foreign Issuer
i. With no substantial US interest in their securities; OR
ii. Directing offering to residents of a single non-US country
b. U.S. Issuer directing offering to residents of a single non-US country
3. Requirements
a. Must be offshore transaction + no directed selling efforts in US
Rule 903(b)(2)
9. Moderate risk of flowback
10. Issuer
a. Ineligible for 903(b)(1) and
i. Foreign Issuer
1. Reporting companies offering equity securities; OR
2. Reporting or non-reporting companies offering debt securities
30
ii. US Issuer with securities trading in US markets and offering debt securities
11. Requirements
a. Must be offshore transaction + no directed selling efforts in US
b. Distribution Compliance Period
i. Cannot be sold to account of a “US person” for 40 days
ii. Must inform securities professionals of the restriction of sale to US persons
c. Offering material must bear legend that securities do not comply with § 5 registration or meet valid
exemption in US
Rule 903(b)(3)
12. High risk of flowback
13. Issuer
a. Any issuer that does not meet 903(b)(1) or 903(b)(2)
14. Requirements
a. Must be offshore transaction + no directed selling efforts in US
b. Distribution Compliance Periods:
i. Debt Securities cannot be sold to account of a “US Person” for 40 days
ii. Equity Securities cannot be sold to account of a “US Person” for 1 year
1. Equity purchasers must agree only to sell or hedge in accordance with Reg S
iii. Must inform securities professionals of the restriction of sale to US persons
c. Offering material must bear legend that securities do not comply with § 5 registration or meet valid
exemption in US
i. Shares of DOMESTIC issuer must bear legend barring transfer except in accordance with Reg S;
ii. ALL issuers must have provision in bylaws or elsewhere empowering it to BAR transfers not in
accordance with Reg S
903(b)(1) Qualifications
(i) A foreign issuer that has no
substantial US market interest
or
(ii) A foreign issuer engaged
in an overseas directed
offering
903(b)(1) Conditions to be
Satisfied
Must be:
(a) Offshore transaction AND
(b) No directed selling efforts
in US
Offering Restrictions
ISSUER SAFE HARBORS
903(b)(2) Qualifications
(i) A domestic or foreign
Issuer offering debt;
(ii) A foreign issuer subject to
Exchange Act’s reporting
requirements offering equity
903(b)(3) Qualifications
All other issuers
903(b)(2) Conditions to be
Satisfied
Same as 903(b)(1)
903(b)(3) Conditions to be
Satisfied
Same as 903(b)(1)
Offering Restrictions
Offering Restrictions
31
None
Transaction Restrictions
None
During the distribution
compliance period:
(a) Each distributor agrees to
conform efforts to
requirements of safe harbor;
AND
(b) All offering material will
bear a legend that securities
have not been registered in
the US without either
registration or an exemption
Transaction Restrictions
During the 40-day
distribution compliance
period:
(a) No sales to the account of a
US person AND
(b) Distributors during the
period must inform securities
professionals of the
restrictions on sale to US
persons
32
Same as 903(b)(2)
Transaction Restrictions
Distribution compliance
period is 40 days for debt and
1 year for equity:
(a) Purchasers during period
must certify they are not a US
person and are not purchasing
for such person;
(b) Equity purchasers during
restricted period must agree
only to sell or hedge in
accordance with Regulation S,
a ’33 Act registration or an
exemption therein;
(c) Shares of domestic issuer
must bear legend barring
transfer except in accordance
with Regulation S; and
(d) All issuers must have a
provision in bylaws or
elsewhere empowering it to
bar transfers not in
accordance with Regulation S
10/2/17
SECONDARY OFFERINGS
*Remember every time someone sells securities is a Primary Offering (unless IPO)
Section 5 shall not apply to anyone other than issuer dealer or underwriter
1. Colloquially an underwriter is a “middle man.” An intermediary between the issuer and the public
2. Per § 2(a)(11), a statutory Underwriter is any person who purchases securities from an issuer or issuer’s
control person with a view to distribution to the public (506, 504 buy to resale statutory underwriter & has
to be covered by a §5 prospectus)
a. Theory: Investors who purchased securities in such transactions may have informational advantages
similar to those of an issuer, so they must disclose their underwriter status to the public
i. If purchased from issuer with view to invest not an underwriter
ii. If purchased from issuer with view to distribute to public underwriter
iii. If purchased from broker with view to distribute to public Not an underwriter
3. Underwriter could be an affiliate, insider, or control person
4. REARVIEW MIRROR TEST
a. SEC looks back at what has/has not happened to determine whether a person is an underwriter
i. Test considers mental state at time of purchase, but later actions substantiate your intentions
5. Must show securities “came to rest”
a. 1 YEAR RESALE RESTRICTION
i. SEC will presume intent to distribute to the public if security is resold within 1 year
ii. After 1 year you can sell to anyone, even though “unregistered” (40% of SE stock is unreg’d)
iii. B/c no longer an underwriter
b. Very, very limited Exception:
i. To get a pass on the 1-year restriction, you must have a circumstance that is PROFOUND and
UNFORESEEN
1. E.g. Child with leukemia and parents need to sell shares to pay for treatment (Jalil)
6. CONTROL PERSON is deemed an Issuer under § 2(a)(11)
a. Any director, officer, or controlling stockholder (and could be underwriter if there is control)
b. Fact-specific
c. A control person cannot resell unless he complies w/ § 5 OR has an exemption
i. E.g. If Bill Gates wants to sell Microsoft stock that he purchased through valid § 5 offering, he must
have Microsoft file a registration statement just for his sale or use exemption
1. Registration Statement would bear legend that says “this is Gates’ secondary offering, and all
proceeds will go to him, not Microsoft”
ii. 506 sale agreements can also include contractual registration rights
1. Issuer agrees to file registration to allow purchaser’s subsequent sales
7. NOTE
a. In a normal § 5 offering context, underwriters CAN resell to the public because the registration
statement does Double Duty
i. It complies with issuer’s requirement to disclose and about who the underwriters are
b. In an exempted transaction context (e.g. § 4(a)(2), Rule 504, Rule 506, or Reg S)
33
i.
Underwriters CANNOT resell to the public because the issuer has not complied with § 5
disclosure, so no disclosure of who the underwriters are.
1. Therefore, these securities are RESTRICTED and not freely alienable
a. To RESELL, Underwriter must EITHER:
i. Wait for securities to come to rest (1 year);
ii. Cause issuer to file reg. stmt. under § 5 to disclose underwriter’s secondary offering;
iii. Find another exemption under which to resell
1. E.g. Rule 144, § 4(a)(1)(1/2), Rule 144A, Reg A
Three Q’s You Must Ask
ii. Was the stock registered? If not, did the stock come to rest? If not, are you a control person?
1. Even if §5, cannot be a control person.
c. Why buy your stocks back? You can either declare dividends (which are taxed), giving cash back goes
to capital gains
Rule 144 Safe Harbor (resale)
Does Double Duty
a. Regulates the resale of two categories of securities
i. Restricted Securities
1. Securities acquired from issuer in an UNREGISTERED offering
a. So, securities sold via 504, 506, Reg S, § 4(a)(2)
ii. Control Securities
1. Securities held by control person, regardless of how acquired
a. Could be both restricted securities and control securities
b. Person who satisfies Rule 144’s conditions is deemed NOT to be an underwriter under § 2(a)(11) and
therefore may rely on § 4(a)(1) exemption for resale
1. UNRESTRICTED Securities (§5 ?):
c. Holders of Unrestricted Securities who are Non-Affiliates (Non-Control Persons)
i. Freely alienable- do whatever you want
d. Control Persons (Affiliates)
i. Can resell immediately IF
1. Reporting company is current in all SEC filings OR
a. NOTE- Reporting Issuers need to be reporting co for AT LEAST 90 days before Rule 144 sale
Non-Reporting Company VOLUNTARILY produces a 15C2-11 (disclosure statement)
b. Must be filed
c. If issuer does not want to produce and file the form, then control person cannot sell
2. Volume Limitation – Rule 144(e)
a. This safe harbor is an accommodation to control persons. So, there is only so much we let
them do. Can only sell a certain number of securities through Rule 144 is every 4-month
period, based on a formula
3. Form 144 Requirement
a. 1-page form; not a disclosure form; Usually filed by control person’s broker
4. MUST sell “regular way brokers’ transactions” – Rule 144(f)
34
a. Cannot use Rule 144 to sell to next-door neighbor; Must sell into anonymous market
b. Exception – Debt Securities
2. For RESTRICTED Securities of REPORTING Issuers:
i. Note – Under the ’34 Act, issuers whose securities are traded on national markets must make
periodic filings with the SEC. These are Reporting Issuers
ii. Reporting Issuers need to be reporting company for AT LEAST 90 days before Rule 144 sale
a. Holders of Restricted Securities who are Non-Affiliates (Non-Control Persons)
i. Cannot sell for 6 months
ii. For months 6-12, non-control person can sell if the reporting company is current in their ’34 Act
filings (Jalil buys MS stock via 506)
iii. After 1 year, ALL restrictions vanish
b. Control Persons - Affiliates
i. If control person bought restricted securities from issuer:
1. He has to wait 6 months (holding period)
a. BUT if control person bought on NASDAQ, he could sell the next day
i. No 6-month holding period
ii. Can only sell if reporting company is current in its SEC filings (if Co. is delayed or tardy in filing,
Bill Gates cannot use 144)
1. This Restriction DOES NOT vanish in 1 year
iii. Volume Limitation – Rule 144(e)
1. This safe harbor is an accommodation to control persons. So, there is only so much we let them
do. Can only sell a certain number of securities through Rule 144 is every 4-month period, based
on a formula
iv. MUST sell “regular way brokers’ transactions” – Rule 144(f)
1. Cannot use Rule 144 to sell to next-door neighbor.
2. Must sell into anonymous market
3. Exemption: Debt Securities
v. MUST file monthly a Form 144
1. 1-page form; not a disclosure form
2. Usually filed by control person’s broker
3. RESTRICTED Securities of NON-Reporting Issuers:
a. Holders of Restricted Securities who are Non-Affiliates (Non-Control Persons)
i. Must have been a non-affiliate for AT LEAST 3 MONTHS
ii. No sales for 1 year; After 1 year, ALL restrictions vanish.
b. Control Persons (Affiliates)
i. No sales for 1 year
ii. After 1 year, issuer must VOLUNTARILY produce a 15C2-11 (disclosure statement)
1. Must be filed
2. If issuer does not want to produce and file the form, then control person cannot sell
iii. Volume Limitation – Rule 144(e)
35
1. This safe harbor is an accommodation to control persons. So, there is only so much we let do.
Can only sell a certain # of securities through Rule 144 is every 4-mo period, based on a formula
iv. Form 144 Requirement
1. 1-page form; not a disclosure form
2. Usually filed by control person’s broker
v. MUST sell “regular way brokers’ transactions” – Rule 144(f)
1. Cannot use Rule 144 to sell to next-door neighbor.
2. Must sell into anonymous market
a. What’s the market? OCTBB – Over The Counter Bulletin Board
3. Exception – Debt securities can be sold non-regular way
Fungibility Doctrine
c. When an investor has purchased both restricted and non-restricted securities of the same class (e.g.
common stock), as an economic matter, it is impossible to distinguish between the shares
i. For purposes of the holding period, all shares are treated as RESTRICTED
US v. Wolfson: D was a corporate raider whose defense was that during the period they operated, they
didn’t know about the registration law. The court said that they were too busy to bother w/ registration.
● 144A deals w/ QIB’s – qualified institutional buyers
● 144A- if it is a security being sold by issuer is not by a class that is traded publicly (not MS) and traded by
BIG QIB’s can sell the next day
Rule 144
Unrestricted
Non-control person (Jalil)
Control person (Bill Gates)
Freely alienable
No holding period but can resell immediately only if:
securities
- Reporting company is current in all ’34 Act filings OR
non-reporting company files Rule 15c2-11 disclosure
w/FINRA
- Form 144 is filed
- Volume limitations are met
- Executed via ordinary brokerage transaction (& subject
to manner of sale requirements ("trickle" rules)
Restricted
Six month holding period.
securities of
Can resell after 6 month holding period only if
- Issuer is current in all ’34 Act filings (e.g., 10k filing)
reporting (public)
After 6 months: Can sell on
- Form 144 is filed
company
sole condition that issuer is
- Volume limitations are met
current in its '34 Act filings.
- Executed via ordinary brokerage transaction (i.e. on
(e.g. 504,505,506
offering)
NASDAQ) (& subject to manner of sale requirements)
After 1 year holding: Can resell
without limitation. All
restrictions fall away.
36
Restricted
1 year holding period.
securities of non-
Can resell after 1 year holding period only if
- Issuer files Rule 15c2-11 disclosure w/FINRA
reporting (non-
After 1 year: All restrictions fall
- Form 144 is filed
public) company
away. (i.e. cannot resell w/in 1
- Volume limitations are met ("trickle" rules) (page 296 EE)
yr)
- Executed via ordinary brokerage transaction (& subject
to manner of sale requirements)
Rule 144A
Another RESALE safe harbor from 4A and 2A11 (not issuer or dealer)
1. Allows holders of RESTRICTED securities or control persons to sell to Qualified Institutional Buyers
(QIBs) without being deemed an underwriter under §§ 2(a)(11) and 4(a)(1), the next day
a. QIBs can sell to other QIBs; basically a 506 structured for QIB’s
2. Rule 144A(b)
a. Says any person, other than the issuer or a dealer, who offers or sells securities in compliance with
conditions in (d) shall be deemed not to be engaged in a distribution of such securities and therefore
not to be an underwriter within the meaning of §§ 2(a)(11) and 4(a)(1) of the ’33 Act
i. So, issuers and dealers CANNOT use this 144A safe harbor
3. Rule 144A(d)
a. Sets forth conditions, including that the buyer must be a “qualified institutional buyer” (QIB) and
securities exchanged MUST be those NOT traded on any national exchange (e.g. NYSE, NASDAQ)
4. Rule 144A(a)
a. Defines QIB
i. Any insurance company, employee benefit plan, investment company, or investment advisor that
owns and invests on a discretionary basis AT LEAST $100 million in securities
5. Rule 144A limits the aftermarket
a. You can sell restricted securities the very next day to QIBs
§ 4(a)(1)(1/2)
Sales to sophisticated investors in non-public offering
1. Another way for holders of restricted securities and/or control persons to avoid § 5
2. § 4(a)(1) - § 5 applies to issuers, underwriters, and dealers
a. Redrafted to say that § 5 applies to issuers, underwriters, and anyone who bought restricted stock and
tries to sell within 1 year (intent doesn’t matter), and control persons
3. § 4(a)(2)
a. § 5 shall not apply to transactions by an issuer NOT involving an offering to the public
i. Another example of POOR DRAFTING
37
1. Congress obviously also intended to exempt underwriters and dealers (control persons) who do
not make offers to the public. Otherwise, underwriters and dealers who offered securities that
did not involve the “public” would have to go through § 5.
a. Therefore, § 4(a)(1)(1/2) basically reads “underwriter” and “dealer” into the statute
4. Underwriters and control persons who offer their securities to financially sophisticated offerees need
not comply with § 5 so long as they comply with Ralston Purina’s other requirements
a. No general solicitation
b. Must be sold only to sophisticated investors
c. Information (disclosure or access)
5. Hypos:
a. Can Bill Gates sell MS common stock to retired chairman of investment company w/o § 5 disclosure?
i. Yes
1. Under § 4(a)(1)(1/2)
a. Assuming no general solicitation and that adequate information given (disclosure or access)
b. Can Jalil, who acquired Coca Cola stock last month in a 506 offering, sell the restricted stock to a
financially sophisticated business school professor without § 5?
i. Yes
1. Under § 4(a)(1)(1/2)
a. Assuming no general solicitation and that adequate information given
2. Need not wait until Rule 144’s holding period ends
RECAPITALIZATIONS
Spinoffs
1. When a company “splits off” one of its businesses to became an independent company
a. E.g. Acme has a bunch of assets, including holdings in Pet Food companies
i. Big Corp with multiple businesses—pet food company, trucking company, beer company—wants
to get out of pet food business b/c it does not fit its corporate profile. It could ask a placement agent
(Goldman) to find a buyer, OR it could “spinoff” the business to stand alone.
ii. Big Corp has 1,000,000 shares outstanding. It issues dividend: one share of pet food company stock
for each share outstanding (2-for-1 split). For the shareholders, nothing has changed—they own
the same basket of goods. (Before SH A owned, Big Corp including pet food co; now they own Big
Corp and Pet Food stock)
b. Problem:
i. Because Acme did not make an offer or sale as defined by § 2(a)(3), it did not fall within § 5 b/c
§5 only applies to sales
1. Just issued new shares to the public without disclosure
ii. The spinoff was not a FOR VALUE transaction (gave away the stock for free)
1. Remember:
a. Offer – Every attempt to offer or dispose of a security FOR VALUE
b. Sale – Every contract of sale or disposition of a security FOR VALUE
i. Must focus on "for value" to see if any "disposition" qualifies as a sale.
ii. TESTS: Whether a disposition will be found to be "for value":
38
1. One test is whether the recipient had to make an "investment decision". If such a
decision (e.g. buy/sell) must be made, it is a disposition "for value."
a. If the stock did not just show up, would have to go through §5
iii. Alternative test: If the disposition results in a benefit to person who disposes (alienates)
of the security §5
1. Hypo: A issued debenture w/ 12% interest rate. A wants interest rate reduced to
2%. Is this a for value transaction? Yes. Basically this would change the security.
Need to consider Section 5.
2. Hypo: Convertible Debenture- ea. Db $1000, due in 10 yrs, from 8-10 yrs can convert
it into 100 shares of common; Mom and Pop America, may want to convert by yr 8
a. For Value: Co. must register the stock, b/c an investment decision must be made
2. So, spinoffs have no § 5 disclosure implications
3. NOTE: SEC now requires ALL sales of spun-off shares by an affiliate to comply with Rule 144
a. Also requires that the spun-off company have been a reporting company for 90 days prior to resale
Reverse Mergers
1. Many companies (e.g. offshore companies) that want to gain access to US capital markets but avoid § 5
disclosure will “reverse merge” into dormant US reporting companies
a. Acquiring company is typically a shell that remains after bankruptcy or sale of business
b. Target’s shareholders trade their shares in the target for the acquiring corporation’s shares
c. The surviving corporation will then set up a Private Investment in Public Equity (“PIPE”) deal
i. Allows the issuer, which is often distressed, to finance itself through a nonpublic offering
1. I.e., a 506 deal
2. These are a bad idea
a. Reporting companies must file Form 10-Ks annually, 10-Qs quarterly, and Form 8-Ks monthly to notify
investors of material events
i. Typically 8-Ks are brief, but with a reverse merger, the 8-K looks a lot like a registration statement
1. Ends up costing the company nearly as much as a registration statement under § 5 would
b. Not only that, but the old target corporation must go to shareholders and tell them that their shares are
now diluted (since the acquiring corporation usually has some (if not many) shareholders
Exchange Offers - § 3(a)(9) (this is a TRANSACTION, not security)
1. Allows an issuer to exchange one security for another without § 5 disclosure
a. Debentures for common stock trade; even though this is a disposition for value
2. Double Exclusivity Test:
a. 1. Exchange is exclusively with existing security holders, AND
b. 2. Exchange is exclusively security for security (no $, no boot)
i. Cannot have a BOOT – no commission or other remuneration can be given directly or indirectly
1. E.g. Yankee tickets
3. Warning
a. Potential for Integration
i. Issuer must be careful that integration does not blow the exemption; requirement that the exchange
is exclusively with existing security holders
39
1. E.g. If issuer offers equity in exchange for outstanding debentures and around the same time
offers common stock to new investors under Rule 506, the SEC will integrate the two offerings
into one transaction
a. The first exclusivity requirement—that the exchange be exclusively with existing security
holders—will not be met and exemption will be blown b/c co-offering is to new investors
To avoid integration, issuer should wait 6 months between the transactions
EXEMPT SECURITIES §3
1. Congress decided to exclude certain securities from § 5 disclosure all together
Government Securities - § 3(a)(2)
1. § 3(a)(2)- US-issued or US-guaranteed securities are ALWAYS exempt from § 5
a. STATE & MUNICIPAL securities depend on type of obligation
1. General Obligation Bond (“G.O. Bond”)
a. Exempt from § 5 because of full faith and credit (pledged repayment; e.g., taxing power) if
the governmental entity supports the bond
2. Industrial Development Bond (“IDB Bond”)
a. Used to finance public housing, bridges, tunnels and thruways, sanitation systems, airports,
and other infrastructure – need to encourage people to invest
b. Typically NOT backed by full faith and credit.
i. Instead, backed by revenue they generate (e.g. tolls, usage fees, etc.)
c. IRS sets criteria for which IDBs are tax-exempt and which are not
i. Tax-Exempt IDBs (don’t have to pay taxes, even though low return) - Exempt from § 5
1. E.g. Muni Bonds (interest is not included in income)
ii. Taxed IDBs- ARE SUBJECT to § 5
Commercial Paper - § 3(a)(3)
1. § 3 (a)(3)- Has nothing to do with commercial notes under Reves
a. Commercial Paper – an unsecured promissory note with short-term fixed maturity date
i. 9 months or less
b. Usually issued by big boys to other big boys for large quantities of cash
i. E.g. GE borrowing $40 million cash every two weeks to make payroll
1. Pays it back in a matter of days, tops
2. SEC limits this exception to issuers with AAA short-term credit rating
Religious and Fraternal Organizations - § 3(a)(4)
40
1. § 3 (a)(4)- Any security issued by a person organized and operated solely for religious, educational,
benevolent, fraternal, charitable, or reformatory purposes where NO part of net earnings inures to any
person or individual is exempt from § 5
i. E.g. The Catholic Church, Knights of Columbus, Rotary Club
2. So these players can sell bonds and debentures without registration
Savings and Loans Institution Securities - § 3(a)(5)
1. § 3 (a)(5)- Securities issued by a savings and loan institution, building and loan association, cooperative
bank, etc., supervised by a state of federal authority are exempt from § 5
2. Theory: These are heavily regulated by banking authorities, so they are exempt from § 5
Insurance Policies - § 3 (a)(8)
1. § 3(a)(8)- Under Howey analysis, insurance policies are securities (fits the three prongs)
a. BUT because they are so heavily regulated by state commissions, they are exempt from § 5
Other Exempt Securities
1.
2.
3.
4.
§ 3(a)(6)- Railroad equipment and trust interest (because this was enacted in the ‘30s)
§ 3(a)(7)- Certificates issued by bankruptcy trustee (because they are regulated by Bankruptcy Court)
§ 3(a)(12)- Any equity position from a bank (because they are highly regulated by states)
§ 3(a)(13)- Securities issued by religious groups for structures/plans
41
10/10/17 Class 7
LIABILITY
1. Pre-’33 Act- Was difficult to be a plaintiff in a securities lawsuit. Had to prove CL FRAUD
i. Elements of CL Fraud
1. Misstatement
2. Scienter (intent to commit the fraud)
3. Privity (statement was made to the plaintiff) (person suing must have conn. to stock at issue)
4. Reliance
5. Causation (misstatement caused the loss)
6. Harm/Damages
2. Congress enacted TWO alternative remedies to CL Fraud in the ’33 Act
a. Section 11
b. Section 12 + 13 + 15
3. Statute of Limitations- Section 13
i. 1 & 3 rule- (Statute of Limitations/Statute of Repose)
1. 1 year from personal discovery of violation, & in any event, 3 years from occurrence of violation
4. § 15- If the issuer is liable under §§ 11 or 12, then controlling person is also liable w/ issuer, if one exists
SECTION 11
1. Section 11 – Civil Liabilities on Account of False Registration Statement
2. Remedy = DAMAGES
3. ONLY APPLIES to § 5 registered public offerings (see § 11(a) below)
a. Does NOT apply to preliminary statements
b. Can sue only for final prospectus- when registration statement becomes effective
4. Elements for § 11 claim- any untrue statement of material fact” in the registration statement. Must be material.
a. Misstatement
b. Privity- doesn’t have to be from Issuer, any person can sue. BUT TRACING requirement.
i. Only someone who bought those exact securities can sue
ii. Daisy-chain liability if you can show exact chainX sold to A, A sells to B, B sells to C
c. Damages
i. Says NOTHING about Scienter, Reliance, or Causation
5. § 11(a)
a. “In case any part of the registration statement, when such part became effective, contained an untrue
statement [misleading] of a material fact or omitted to state a material fact required to be stated
therein or necessary to make the statements therein not misleading, any person acquiring such security
(unless it is proved that at the time of acquisition he knew of such untruth [misleading statement] or
omission) may, either at law or in equity, in any court of competent jurisdiction, sue . . . “
42
b. Persons who MAY be sued:
i. Every person who signed the registration statement (this includes the issuer itself)
1. Issuer CANNOT indemnify directors and officers for liability under § 11(a)
a. But they can buy D&O Insurance and hire their own counsel
ii. Every person who was a director of the issuer (or partner, or person performing similar function)
iii. Every person who was becoming a director (or partner, or person performing similar function)
iv. Every Expert
1. E.g. accountant, engineer, appraiser, etc., who has with his consent been named as having
prepared or certified any part of the registration statement, or valuation therein
v. Every Underwriter
vi. NOTE: Plaintiff can sue all of these persons individually
c. Persons who MAY sue: Exception to Who May Sue: “unless it is proven…he knew of the untruth.” Do
not want to allow people to buy into lawsuits. If P knew about misstatement & bought suit, cannot sue
6. § 11(b) – Due Diligence Defense (words due diligence never appear but that’s what it is)
a. No liability if any defendant, OTHER THAN THE ISSUER, can prove:
i. After reasonable investigation,
ii. Formed a reasonable ground to believe Objective belief
1. and did believe that at the time the misstatements or omissions became effective, (Subjective belief)
a. They were not material and misleading
b. NOTE – Issuer has STRICT LIABILITY (assuming that misstatement was responsible for decline in
stock price)
c. So, every potential defendant MUST be a Sherlock Holmes, Magnum PI, CSI investigator – b/c D has to
show he did everything he could to ensure that the registration statement wasn’t false.
7. § 11(c)
a. Reasonable Investigation
i. As to Experts:
1. Bright-Line Rule
a. Held to the Industry Standards- E.g. If industry reqs petrochemical geologist to check sonar
at every 8 feet, but expert checked only at every 100 feet, then no reasonable investigation
b. Question of fact as to what industry standard is
ii. As to Non-Experts:
1. Sliding Scale Approach
a. Depends on position, depends on area of expertise, more knowledge = higher standards
b. Have qualified right to rely on experts
2. Two-Step Process:
a. Must investigate, AND
b. Have no reason to doubt the accuracy of the registration statement
8. Privity- You MUST have privity
i. You may have Daisy Chain Privity
1. E.g. Issuer sells to underwriter, who sells to A, who sells to B, who sells to YOU
43
a. If you can positively prove (e.g. forensic analysis) that the shares you own are exactly the
same shares that A bought from the issuer/underwriter, then you may sue
9. § 11(e) – DAMAGES
a. “May seek damages that represent difference between amount paid for security (NOT exceeding the
amount at the time the security was offered) and:
i. VALUE at time suit was brought, OR
1. Value is not necessarily price. Gives plaintiff chance to argue negative information was not
yet impounded in price at time of suit
ii. Price at which the security was sold into the market, OR
1. E.g. Stock sold to A for $10, and stock falls to $2.
a. Damages = $8
2. E.g. Stock sold to A for $10, from A to B for $12, B to C for $20, C to D for $30, price fell to $2
a. Damages are still $8, not $28
iii. Price at which the security was sold after suit but before judgment (if less than the first amount)
b. Damages CAPPED at $10,000,000
c. Causation Defense- If defendant can prove that the stock price went down for reasons other than the
misstatement, then damages in full are NOT recoverable
10. § 11(f) – Joint and Several Liability
a. Each defendant is 100% responsible for judgment amount
i. Exception: Outside Directors- Court may set damages proportionally for outside directors
b. Each defendant may attempt to recover contribution from other defendants
11. § 11(g) – Damages Capped at security’s offering price
a. Issuer/Underwriter cannot lose more money than what it took in
12. Literal Trading Requirement- Often a buyer or even a broker never requests physical delivery of a stock; if
this is the case, the securities are held in “street name” by or on account for the broker or buyer
i. Courts have read § 11 LITERALLY to impose a TRADING REQUIREMENT on a plaintiff
Section 12
1. Section 12 – Civil Liabilities in Connection with Prospectus and Communications
2. Remedy = Rescission (money back generally, unless sold. If sold, then damages)
3. § 12(a)(1)
a. Any person who offers or sells a security in violation of § 5 shall be liable for rescission
b. Any “person” who offers or sells a security in violation of § 5 shall be liable to the person purchasing the
security for the consideration paid (rescission) for such security = FAILURE TO REGISTER
44
i.
Strict Liability- E.g. Investor who purchased in § 3(a)(11) and Rule 135 and then sells out-of-state
before 9 months. Intrastate exemption is blown as to every sale; offering now violates § 5
a. Everyone gets their money back
2. E.g. Issuer does 506, thinks it sold to 35 non-accredited, financially sophisticated investors, but
actually sold to 36.
a. So long as it’s insignificant and issuer tried in good faith to follow the rules, then SEC
might grant leniency under Rule 508
3. No Due Diligence Defense here
4. § 12(a)(2)
a. Any person who offers or sells a security by means of a prospectus or oral communication which
contains a misleading statement of material fact or omission shall be liable for rescission
b. It’s like a put on the share. If the stock goes up, you won’t sue. If it goes down, you sue and get
money back. A very simple remedy.
c. Due Diligence Defense*
i. Issuer did not know, and in the exercise of reasonable care could not have known, about the
material misstatement Lack of Culpability
5. Direct Privity Required
a. No Daisy Chain here, unlike Section 11
i. Purchaser must have purchased directly from the issuer of the prospectus or oral communication
ii. Example: suppose you sell stock to 1000 people, and in 500 instances you forgot to send the
prospectus. You are ok for the other 500 (though the 500 who didn’t get the prospectuses can sue
you under §12(a)(1). The minority view is that you can set up a chain of privity.
iii. Pinter v. Dahl The SEC Ruled that the term “seller” means that only those in privity with the buyer
could be liable, so only a direct purchaser can sue the issuer, underwriter, or dealer.
6. § 12(b) – Loss Causation
a. If defendant can show that the stock price went down for reasons other than the misstatement, then
that amount is not recoverable
i. NOTE: Jalil – this is a rescissionary statute. You get your money back, period. This is no
diminution in value. This actually LIMITS recovery. Jalil: This makes absolutely no sense because
the remedy under §12 is rescission; there is no diminution in value under a rescissionary statute
7. Gustafson v. Alloyd Co. (1995)
a. Holding: The, rather than any written communication or private agreement as § 2(a)(10) clearly defines
i. Limited § 12’s applicability to § 5 offerings, so that ’33 Act contains two successive sections
addressing the same exact violation but with two senseless differences
1. § 11 imposes strict liability on an issuer’s misleading statement of material fact while § 12
provides issuers with due diligence defense
2. § 11 provides plaintiffs with damages while § 12 provides plaintiffs with rescission
b. This case says that the ’33 Act does not provide plaintiffs with a remedy for damages caused by a
misleading statement of material fact in any exempt offering, primary or secondary
8. ***Congress’s Attempt to “Correct” Gustafson: JOBS Act of 2012 and § 3(b)(2)***
45
a. § 3(b)(2) says “civil liability provision in § 12(a)(2) shall apply to sales under § 3 – Exempted
Securities
b. THIS PROVISION IS CALLED “REG A PLUS”
Section 17 – Fraudulent Interstate Transactions
1. SEC’s antifraud statute
2. No private right of action; used by SEC to bring any action (Limited to SEC enforcement actions)
3. “It shall be unlawful for any person in the offer or sale of any securities to employ any device, scheme, or
artifice to defraud; to obtain money or property by means of any untrue statement of material fact; or to
engage in any transaction, practice, or course of business which operates or would operate as a fraud on
the purchaser” – SEC can do whatever it wants
4. § 17(a)(1)- Makes it unlawful to “employ any device, scheme, or artifice to defraud”
i. Intent to proscribe only knowing or intentional misconduct (Scienter requirement)
5. § 17(a)(2)- Prohibits any person from obtaining money or property “by means of any untrue statement of
material fact or any omission to state a material fact”
i. No mention of scienter
6. § 17(a)(3)- Unlawful for any person to engage in any transaction, practice, or course of business which
operates or would operate as a fraud or deceit
i. Focus is on effect of conduct rather than culpability
ii. No mention of scienter
7. Sarbanes-Oxley Act § 8A(f)
a. Prohibits persons who have violated § 17(a)(1) from serving as officers or directors of reporting
companies
46
10/16/17 Class 8
SECURITIES EXCHANGE ACT OF 1934
●
While the ’33 Act is a consumer protection statute, the ’34 Act is a regulatory statute. It regulates the
industry (exchanges, broker-dealers, public companies, insiders, tender offers) and created the SEC.
Preamble: national public interest in the market, so need regulatory control over officers, directors, etc.
About regulating companies whose stock is traded by OTHERS (not issuers/offerings under ’33 Act).
1. Statute of Limitations (2/5)
a. Sarbanes-Oxley Act (2002) § 804
i. 2 years from personal discovery of ’34 Act violation, AND, in any event, 5 years from occurrence of
the ’34 Act violation
2. Section 2- Transactions in securities commonly conducted in markets and OTC are affected with a national
public interest which makes it necessary for gov. to provide regulation & control
3. Section 4
a. Establishes the Securities & Exchange Commission
i. Five Commissioners appointed by President on advice and consent of Senate
1. No more than 3 members may be from same political party
a. Joe Kennedy – First Chairman of the SEC
ii. 4 Principal Divisions
1. Div. of Corporation Finance
a. Administers federal securities laws’ disclosure requirements
2. Div. of Trading and Markets
a. Oversees operation of secondary trading markets
3. Div. of Investment Mgmt.
a. Administers ‘40 Act and Advisors Act
4. Div. of Enforcement
a. Responsible for investigations and enforcement actions
5. (5th Div. created in 2009 – Div. of Risk, Strategy and Fin. Innovation Overview
a. SEC’s “think tank”
4. Section 5- Shall be unlawful for a broker, dealer or exchange to be in business unless it is registered as a
national exchange
5. Section 6 – National Securities Exchanges
a. Requires securities exchanges to register with the SEC
6. Section 7 – Margin Requirements
a. NOTE – Only Section in all of the securities laws that is NOT regulated by the SEC
i. The FEDERAL RESERVE regulates Section 7
b. To prevent excessive use of purchasing securities on credit, Federal Reserve regulates margin
requirements in leveraged transactions
c. Margin- Amount borrowed. “Buying on Margin” means borrowing money from a broker to finance
purchase of securities. Brokers do this to get increased sales commissions
47
1. When collateral value drops below margin amount, the broker calls investors and makes a
MARGIN CALL: Broker demands that investor deposit add’l $$$ (more collateral) in account
d. Today, maximum margin percentage is 50%
i. Provides sufficient cushion so that if stock starts to fall, brokerages will not engage in panic-selling
ii. 1929- people would buy on margin & mkt was highly leveraged, when margin calls went out, no
one had the money
e. Long a stock- investing it w/ anticipation it will go up
f. Short a stock- borrow stock, sell them, and cover- make money on the decline
7. Section 9 - Prohibition on Manipulation of Security Prices
a. § 9(a)
i. It shall be unlawful to create false appearance of active trading in a security.
1. Every transaction must be a bona fide arm’s length transaction
a. Intended to outlaw collusion between broker dealers who owned securities and ramped up
price by buying more securities at progressively higher prices, only to dump all of their
shares on the market
ii. No Pump-and-Dumps
iii. The price of stock is arrive at by a willing buyer and seller (what someone is willing to pay)
8. Section 10 – Antifraud Section
a. § 10 creates a private right of action (contrary to ’33 Act § 17(a))
b. § 10(b)
i. It shall be unlawful for any person to use or employ, in connection with the purchase or sale of any
security, registered or not, any manipulative or deceptive device or contrivance in contravention of
such rules or regulations as the SEC may prescribe
1. See Rule 10b-5
9. Section 12 – Registration Requirements for Securities (Reporting Companies as a CLASS)
a. § 12(a)
i. It is unlawful for any broker, dealer, or exchange member to effect transactions on a national
securities exchange in a class of securities that are not registered
1. An issuer who wishes to create an aftermarket for its securities must register the entire class of
securities under § 12 by filing an application [registering] with the exchange itself and the SEC
b. Voluntary Reporting Company (§ 12(b)): if you want to be traded in the public market): file a Form 10
(similar to a registration statement or 10-Q or 10-K) or file a Registration Statement
c. Publicly registered does not mean public traded
d. Who is required to register?
i. § 12(g)
1. Any issuer with
a. 2,000 or more shareholders (or more than 500 non-accredited investors), AND
b. $10,000,000 or more in assets (must register even though not trading publicly)
2. If these conditions are met, then the company is now a Reporting Company thanks to § 12(g)
a. E.g. MasterCard is NOT traded on any exchange (only banks can be shareholders) but it is a
reporting company for purposes of § 12
e. How do you register?
i. If issuer is doing a § 5 offering and files an S-1, that S-1 can serve as registration under § 12
48
ii. If not, you can use Form 10
f. Issuer who filed Section 5 registration statement pretend it’s a Reporting Company for rest of the
year that registration was effective, AND the following year, take a snapshot: if the company meets
part 12(b) or 12(g), must do a § 13 reporting; if not, can “go dark” (if not traded and less than 2K SH)
10. Section 13 – Requirements for Reporting Companies (Periodical and Other Reports)
a. § 13(a)
i. Every issuer with a class of securities registered under § 12 shall file periodic reports with the SEC
1. These reports provide public disclosure
ii. Form 10-K Annual report (looks a lot like S-1)
1. Very detailed
2. Requires audited financials
iii. Form 10-Q Quarterly report
1. Does not require audited financials
iv. Form 8-K Monthly report
1. Usually short; update for material events
b. What if an Issuer doesn’t meet the 2,000 SH threshold (or 500+ non-accredited investor threshold) in
§ 12 AND chooses not to trade on capital markets?
i. Doesn’t matter. Issuer MUST file under § 13(a)
1. Must file § 13(a) periodic reports for the remainder of the year, AND
a. ALL of the § 13(a) periodic reports for the following year
2. After that, you “go dark” – do not have to file anymore
c. § 13(d)
i. Every person who acquires 5% or more of a class of securities registered under § 12 must, within 10
days, file a Schedule 13D with the SEC
1. Investor MUST disclose:
a. Who you are- background, identity, residence, and citizenship
b. How much stock you own
c. Where it got the money to purchase
d. Intentions
11. Section 14 – Proxies (and Tender Offers)
a. The Williams Act is embedded in Section 14(d)
i. Named for Harrison Williams who later went to jail for 20 yrs for taking bribes on floor of Congress
b. § 14(a)
i. Any proxy solicited with regard to a security registered under § 12 must comply with proxy rules
1. Proxy Agent legally authorized to act on behalf of another party
ii. A proxy statement must accompany every request for a proxy
1. This is a disclosure form an issuer gives to shareholders (and files with the SEC)
a. Disclosure and background on what is to be voted on to make an informed decision
c. § 14(d) (Williams Act)
i. Anyone who intends to make a tender offer for securities registered under § 12 must announce
intent to buy certain % of outstanding securities and name an offer price
49
1. Offeror must buy all shares at the same price
d. Rule 14D (SEC promulgation)
i. Requires offeror to file a Schedule TO that discloses this information as well as where the offeror is
getting the money to make tender offer purchases, intentions, etc.
ii. Disclosure (schedule TO):
1. What are the intentions?
2. How much do you want?
3. What price are you going to pay?
4. Where are you getting the financing?
e. Creeping Tender Offer
i. E.g. Investor buys 5% of outstanding common stock. Wants to buy more and amends 13D. Buys up
to 8%. Wants more, amends 13D. Buys up to 12%.
1. SEC will suspect investor intends to make a tender offer, which triggers §14 disclosure
requirements
12. Section 15 – Registration and Regulation of Brokers and Dealers
a. Authorizes SEC to register and regulate brokers and dealers—ALL have to be reg. w/ SEC
b. NOTE – SEC has delegated mundane day-to-day administration to FINRA; SRO (self-regulation)
i. FINRA Financial Institutional Regulatory Authority
1. Run by broker-dealers; an industry association
c. SEC still has veto power over FINRA
d. A convicted felon can’t be associated with FINRA for 10yrs. BUT it is possible to get an exemption.
There will be a hearing to determine if you can become a registered broker/dealer. 10yr-period can also
be extended for fear of terrorists/organized crime infiltration.
13. Section 16 – Directors, Officers, and Principal Stockholders
a. § 16(a) (Sarbanes-Oxley)
i. Every officer, director, or 10% or more shareholder who owns securities in a class of securities
registered under § 12 must file electronically with SEC within 48 hours every time the director,
officer, or shareholder buys or sells even a SINGLE security of that class
ii. SEC requires 3 Forms:
1. Form 3 Filed the day person becomes officer, director, or 10% shareholder
2. Form 4 Filed electronically 48 hours after buying/selling security registered under § 12
a. Requires name, position, how many shares you own, how many you bought/sold, and the
price, options (if any), etc.
3. Form 5 Annual update
a. Annual form that adds up all Form 4s filed
b. § 16(b) – Short-Swing Profit Rule
i. Any officer, director, or 10% or more SH who buys and sells OR sells and buys a security of a class
of securities registered under § 12 within 6 months, and makes a profit, must surrender that profit
to the company
50
1. If the company doesn’t come after you, any SH can bring a derivative action on behalf of
company, and the company must pay the attorneys’ fees
RULE 10b - 5 (5th rule)
Fraud in the connection with the PURCHASE or sale of a security
1. SEC Rule 10b-5
a. It shall be unlawful for any person:
i. (a) to employ any device, scheme, or artifice to defraud,
ii. (b) to make any untrue statement of material fact or to omit to state a material fact necessary in
order to make the statements made, in light of the circumstances under which they were made, not
misleading, or
iii. (c) to engage in any act, practice, or course of business which operates or would operate as a fraud
or deceit upon any person
iv. In connection with the purchase or sale of ANY security registered on an exchange or not
2. Who Can Sue?
a. Blue Chip Stamp v. Manor Drug Stores
i. Standing requires that plaintiff actually purchased or sold a security
1. “In connection with the purchase or sale of any security”
ii. Person who held/passed on buying cannot sue, even if in reliance on misleading statement
3. Who Can You Sue?
a. Primary violators and secondary violators.
b. Cannot sue aiders and abettors
4. SEC v. Texas Gulf Sulphur (2d Cir. 1968)
a. Facts: Mining company mined industrial minerals. Stock was trading at $10. Rumor began circulating
that company found major deposit of industrial minerals. Stock climbed. CEO put out press release
denying rumor. Stock fell back to $10. Rumor was actually true, and CEO knowingly lied.
b. SEC Rule 10b-5 (above)
i. Compare § 11 of ’33 Act, where damages are limited to securities that issuer offered and sold with
respect to a registration statement containing a misleading statement of material fact
c. “In Connection With”
i. Company need not have sold 1 share
ii. Damages are NOT limited to a particular offering or by an offering price
1. Damages could be the ENTIRE MARKET
d. Holding: Texas Gulf Sulphur, through its officers, lied and thus is liable to everyone who
purchased or sold the security, even though it did not itself sell one single share
e. Analysis: They were liable b/c it was a misstatement in the connection of any purchase or sale, not
necessarily w/their own. Only requirement is that statement “touched” the purchase or sale of
ANYONE’s security. As long as someone traded in connection with your lie.
f. B/c no privity requirement, damages could be astronomical
i. Note: unlike §§ 11/12, a person liable even though they have not sold the stock (no privity).
ii. 11- recovery was the amount raised; here no privity
51
g. Always ask client: IS IT TRUE?
5. Private Securities Litigation Reform Act of 1995 (“PSLRA”)
a. Congress thought P’s abusing Rule 10b-5 Adopted PSLRA to cut back on securities fraud cases
b. Requires:
i. Plaintiffs MUST PLEAD WITH SPECIFICITY exactly which statements were misleading
ii. Plaintiffs must show Misstatement, Scienter, Reliance, Causation, and Damages
6. Elements of Rule 10b-5
a. Material misstatement
i. Materiality: A fact is material is there is a substantial likelihood that a reasonable investor would
consider it important in deciding whether to invest
1. TSC Indus. Co. v. Northway, Inc.
b. Scienter
i. Need INTENT to defraud, in conn. w/ purchase or sale of security
1. Negligence is NOT enough
a. Ernst & Ernst v. Hochfelder
2. Recklessness may be enough; circuits are SPLIT, but majority view is Not Enough
c. Causation
i. Misstatement has to have been proximate cause of the loss
1. Can prove usually through the lowered stock price
d. Reliance
i. But for the misleading statement or omission, plaintiff would not have bought/sold
ii. Fraud on the Market Theory
1. Presumes reliance because all buyers and sellers rely on the market, and any misstatement is
factored into the price.
e. Damages
i. Limited to actual damages
ii. Cannot be punitive
iii. Diminution of loss for other factors may be deducted from damages
f. NO PRIVITY (which was needed for CL Fraud)
i. Section 11 requires privity. Here, we do not need it.
1. EX: scientist wants nobel, article in journal for neurologists, a drug didn’t work but said it did.
People traded. Was it reasonably foreseeable that this misrep in a tech magazine would be
used by buyers and sellers in securities? Ct said yes – Educated Investors would rely on these
tech magazines and read them; BUT no scienter.
a. No scienter
2. 10b5: violated when assertions made in manner reasonably calculated to influence investing
public.
52
10/23/17 Class 9
INSIDER TRADING
1. Insider Trading Trading on Nonpublic Information
a. Judicially-created doc. based on Rule 10b-5—talks about material misstatements
i. So, there still needs to be a showing of materiality, scienter, reliance, causation, and damages
2. The Insider Trading and Securities Fraud Enforcement Act
a. § 21A- Allows for liability for those who “control” others found liable for insider trading or tipping
1. Liability = greater of $1.1 million or 3x profits made or losses avoided by the controlled person
3. Fiduciary Duty
a. Chiarella v. United States (1980)
53
i.
ii.
iii.
iv.
v.
Facts: Chiarella worked for a financial printer. While printing materials, he put two-and-two
together and guessed the name of a target company in a tender offer. He bought shares in the target
company and made $30,000. He was convicted of trading on nonpublic info & sentenced to jail.
Holding: Conviction overturned
Rule: The mere possession of material, nonpublic information is not a bar to trading.*
1. THERE MUST BE SOMETHING MORE
a. Must be a breach of a FIDUCIARY DUTY
i. A fiduciary cannot trade w/ shareholders. Shareholders are the owners, the bosses. SH’s
hire those who owe fiduciary duties to the company. The fiduciary cannot screw them.
Analysis:
1. Chiarella did not owe anyone a fiduciary duty.
NOTE: Chiarella is still good law, although it’s been overruled twice
1. Misappropriation Theory (O’Hagan/Carpenter): If Court had applied misappropriation in
Chiarella he would have been liable.
2. SEC Rule 14e-3- Categorically bans trading on material nonpublic information concerning
tender offers, regardless of source
b. Temporary Insiders/”Outsider Trading” is ILLEGAL
i. E.g. a crisis expert from a PR firm that company retains to manage company’s image re adverse
news. Expert is temporary insider and owes temporary fiduciary duties. She cannot trade company
stock on basis of material nonpublic information that was shared with her because of her position.
c. DEFENSES: When Can Fiduciaries Trade?
i. BUT FOR / ON THE BASIS OF TEST
1. If the fiduciary can prove that he would have traded anyway, and that the trade was not on the
basis of the material nonpublic information, there is no breach of fiduciary duty
a. SEC v. Adler (11th Cir. 1998)
ii. Rule 10b5-1 (after Adler loss) shifts burden to D
1. SEC will presume that an insider’s trade (w/ info) was on the basis of material nonpublic
information unless, BEFORE learning of the material nonpublic info, the insider:
a. (1) Entered into a written contract to trade, or
b. (2) Instructed another person to sell or purchase a security for his or her account, or
c. (3) Adopted a written trading plan – Gates: good or bad I trade on 3rd day of every month –
Gates cannot influence or deviate from the plan
i. Lore, not law: Usually must be done 3 months in advance of trade
1. Must also give at least 3 months’ notice if you are stopping the plan
2. Note – the above three exceptions are found in Rule 10b5-1(c)
4. MISAPPROPRIATION THEORY: Non-Insiders
a. “The duty of trust and confidence”
i. A person (outsider) commits fraud “in connection w/” a securities transaction and violates §10(b)
and Rule 10b-5 when he misappropriates confidential information for securities trading purposes
in breach of a duty owed to source of information
1. United States v. O’Hagan
54
b. SEC Rule 10b5-2
i. Codified O’Hagan by promulgating non-exhaustive list of 3 scenarios where trading on material,
nonpublic information would constitute breach of a duty of trust under misappropriation theory
1. Whenever person agrees to maintain information in confidence
a. E.g. Carpenter. WSJ reporter had duty to maintain confidentiality of info (to Dow Jones) he
gathered through interviewing corporate executives for “Heard on the Street” columnsleeping w/ broker
2. Duty exists when recipient knows/should know that the giver expects confidentiality based
on past pattern of behavior or course of dealings (no breach of duty trust in employment)
a. E.g. Jalil’s golf buddies. Aren’t close, but they share confidences on the course. If Jalil
discloses a merger, and a friend trades, that friend breached duty of trust and confidence
3. Whenever person receives material nonpublic info from spouse, parent, child, or sibling
a. If you tell someone in family, & they trade, they go to jail. Exonerates tipper but not tippee.
b. Breached duty to source of the info to maintain confidence
c. Barry Switzer at football game, “accidently” overheard two businessmen talking about inside
info court found no liability, no expectation of confidence.
d. Electrician case- went into conference room to change outlet, people talking about
confidential info, came back and changed all outlets to hear, traded in trouble, b/c traded
on purloined or stolen info (same w/ cleaning person trading on info)
c. TIPPER/TIPPEE LIABILITY (non-insiders)
i. Tipper & tippee liable for tippee’s trade on basis of top involving material nonpublic information if
tipper intended to exploit information for personal gain (scienter)
1. IF NO INTENT to exploit for personal gain, then NO liability
2. If TIPPEE does not know where info came from, CAN trade; (a-b-c-d-e-f): f can trade if no idea
a. Dirks v. SEC (1983)- Dirks was broker, public info from co didn’t make sense, called CFO,
asked if they were cooking the books? CFO confesses yes b/c at wit’s end. Dirks shorts stock.
b. If tippee knows or should have known that tipper committed breach of fiduciary duty,
tippee assumes fiduciary duty not to trade
3. Personal Gain
a. Need not be pecuniary ($). Could be reputational benefit that will translate into future
earnings
Regulation FD- result of Dirks
1. FD = “Fair Disclosure”
a. Whenever issuer discloses any info onto the street, shall make public disclosure simultaneously with
intentional disclosure, and promptly with case of non-intentional
2. Targets practice of SELECTIVE DISCLOSURE by issuers to certain securities market professionals,
establishing new requirements for full and fair disclosure by reporting companies
3. No Private Right of Action
4. What is Selective Disclosure?
55
a. Issuer’s temptation to disclose material nonpublic information to securities analysts or institutional
investors in order to gain enthusiastic retail coverage or other benefit
i. Those with the information are able to make a profit or avoid a loss at the expense of those who do
not have the information
5. Regulation FD
a. Whenever an issuer discloses any material nonpublic information to a brokerage firm, investment
analyst, investment company, large stockholder, etc., the issuer shall:
i.
In the case of intentional disclosure, make simultaneous public disclosure
1. E.g. Exxon wants to disclose its quarterly earnings, so also holds an Internet news conference so
that any person around the world can dial in and listen.
ii. In the case of unintentional disclosure, make prompt public disclosure
1. E.g. Exxon’s CEO is out to lunch with institutional investor and accidentally discusses that
rising prices in oil caused a 2% drop in Exxon’s earnings last quarter. Exxon must now
promptly make disclosure to public
b. NOTE – You cannot put yourself in a situation to take information (stolen information), even if the
tipper didn’t intend to tip the material information to you
SEC Rule 14e-3 (Special Rule regarding Tender Offers)
1. ANY person who receives material nonpublic information about a tender offer CANNOT trade on it
a. Doesn’t matter whether info was overheard on a plane or if it was found by stranger on train.
b. Unique, categorical ban on trading on nonpublic information
i. But see SEC v. Adler defense MAY still apply (would’ve traded anyway) (page 48)
1. Not trading “on the basis of” the material nonpublic information
56
ENFORCEMENT OF SECURITIES LAWS
1. Jurisdiction
a. SEC does not have jurisdiction to criminally prosecute, even though the federal securities laws are
criminal statutes
i. Only the Department of Justice can bring criminal actions on the US’s behalf
1. SEC must recommend to DOJ Criminal Division to bring criminal charges, and then 24-member
grand jury must be convinced that charges should be brought
2. Informal Investigations
a. Once SEC staff believes a potential violation of federal securities laws, it conducts an informal
investigation
i. Staff makes general inquiries and request documents, testimony, communications
1. E.g. They send out questionnaires
b. SEC does not have to tell you what’s going on, or if you or your client is a target
c. No subpoena power during informal investigation stage
d. Cooperation is voluntary, but lying is a felony
3. Formal Investigation
a. If Staff decides it wants to continue the investigation, it obtains a formal order from the Commission
and commences a formal investigation
b. This gives the SEC subpoena power
i. Criminal violation to not comply
4. Formal Action
a. At conclusion of Formal Investigation, Staff may determine that no more action is necessary or that a
civil and/or criminal action should be initiated
i. Staff must recommend to the Commission to initiate an enforcement action; cannot do this alone
b. Wells Notice
i. SEC has to tell you that it has gone to the Commission and requested a formal action be brought
against you
1. You can oppose and submit your case as to why the SEC shouldn’t bring an action
a. This is called a Wells Submission
i. Anything you put in the Wells Submission can be used against you.
ii. If Wells Submission is not successful, the Staff may pursue the claims and sue you or
bring a complaint (if a majority of the 5 Commissioners allows the Formal Action)
5. Remedies
a. The SEC can be very creative with remedies (most are settled)
i. Can fine you
ii. Can censure you
iii. Can use any ad hoc remedy it likes; can hand craft relief as it deems appropriate
1. E.g. Joe’s auto body goes public, but keeps terrible records. SEC can make you retain a monitor
(like KPMG) to put together a book-keeping system and make sure it’s operational and effective
iv. Can enjoin you (injunction) to not violate the securities laws ever again
1. NOTE – violating an injunction is itself a felony
a. If there is a next time, the SEC/DOJ has to show only that you violated the injunction
57
6. Who Can SEC come after? Base Analysis on Scienter
a. Primary violators and secondary violators.
i. Primary- intention was to rob a bank
ii. Secondary- involved knowingly; knows robbery is going on and will driver getaway car (accessory)
b. SEC can come after aiders and abettors
i. Opened the door as robber runs outside, but didn’t intend to rob or help rob bank
ii. No requisite scienter here, but why can SEC go after? ’34 Act as statute
10/30/17 Class 11
ETHICAL OBLIGATIONS OF A SECURITIES LAWYER
1. Normal Lawyer- Within the boundaries, ethics, and all courtesies extended to opposing counsel- lawyer
should aggressively advocate client’s case to the maximum
2. SEC v. Nat’l Student Marketing (D.D.C. 1978)
a. Facts: Acquiring company was to acquire NSM. At closing, accountant would not give acquiring
company a cold comfort letter that was required to close the deal. Acquiring company’s counsel called
the CEO and told him, and the CEO said “close anyway.” NSM turned out to be a huge fraud, and the
stock tanked. SEC sued the lawyer.
b. Rule: Securities lawyer owes an obligation to his/her client (like above) AND the investing public
3. SEC RULE 205 (Sarbanes-Oxley Act of 2002 § 307 is the authorizing statute)
a. Reaction to Enron, whose counsel did not question Enron’s practice of setting up unusually high
number of offshore subsidiaries that turned out to be hiding income
b. Sets forth minimum standards of professional conduct for attorneys practicing securities law
i. Preempts state law and professional responsibility rules
ii. Rules were the protection of investors
c. Reporting UP (MANDATORY) (RULE 205)
i. Duty to Report Evidence of a Material Violation
1. If an attorney becomes aware of evidence of a material violation by the issuer or by any officer,
director, employee, or agent of the issuer, the attorney SHALL report such evidence to the Chief
Legal Officer
a. Chief Legal Officer SHALL cause inquiry into the evidence to determine whether material
violation described in the report has occurred, is ongoing, or is about to occur.
i. Chief Legal Officer SHALL report back to the reporting attorney
2. Unless reporting attorney reasonably believes Chief Legal Officer has provided appropriate
response within reasonable time, reporting attorney SHALL report evidence of material
violation to: (i) the audit committee of the board of directors; (ii) if no audit committee, another
committee; (iii) if no other committee, the full board of directors
a. Trumps state law
58
d. Reporting OUT (DISCRETIONARY)
i. If not happy with the end result attorney practicing securities law MAY reveal to SEC, without
client’s consent, confidential information attorney reasonably believes necessary: (i) to prevent
client from committing material violation; (ii) to prevent client from committing perjury; or (iii) to
rectify consequences of a material violation.
ii. An attorney who complies with this part SHALL NOT be liable under inconsistent standards
imposed by any state
1. This provision prevents disbarment under state law for disclosing confidential client info
e. Junior Associates CANNOT HIDE
i. Junior associate can’t just stop b/c partner tells him to. A subordinate attorney SHALL comply with
this part notwithstanding that subordinate attorney acted at the direction of or under the
supervision of another person (aka acted against supervisor)
SARBANES-OXLEY ACT OF 2002
1. Congressional reaction to accounting scandals of Enron and WorldCom
a. If public cannot trust financial representations in a prospectus, the system collapses
2. SERIES of amendments to the securities laws (Sarb-Ox isn’t just one act)
a. Passed in the Senate 99-0
i. One Senator did not show up
3. PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD (PCAOB)
a. Sarbanes-Oxley § 101
i. First thing Congress did – established regulatory authority to regulate the accounting industry
b. Oversees accountants who audit public companies (reporting companies)
i. PCAOB registers public accounting firms that prepare audit reports for issuers of public
securities- Public Company Accounting Oversight Board
ii. Establishes auditing standards, ethics standards, quality control standards
1. In order to protect interest of investors, accurate & indepen. accounting reports of public co’s
2. If you’re a public company have to hire an accountant that is supervised by PCAOB
3. PCAOB requires registration with the SEC of an accounting company because the power to
require registration is the power to regulate. Also regulates the ethics of the accountants.
Must register if auditor will be auditing any public company.
c. REQUIRES that a second partner review the work of a first partner
d. Has authority to bring disciplinary proceedings and impose sanctions
4. AUDITOR INDEPENDENCE
a. Any firm that is doing the annual audit work for a company can only do an independent audit
i. CANNOT do any other consulting work for the company
b. Senior Management CANNOT hire the auditor or set its compensation
i. ONLY a committee of independent directors can serve as the Audit Committee, which hires the
auditor and sets its compensation
c. Senior Management CANNOT fire the auditor
i. ONLY the Audit Committee can fire the auditor
59
d. The partner on the audit from the independent auditing firm MUST be rotated at least every 5 years
e. The accounting firm reports ONLY TO, the Audit Committee comprised of independent directors
f. AUDIT COMMITTEE - § 301
i. Members cannot receive “consulting fees”
ii. At least one member must be a sophisticated
g. An auditor CANNOT go work for a company that it has recently audited
i. Auditor must wait at least 1 year
1. “Cooling off” period
h. It is unlawful for anyone from the issuer to mislead, misdirect, etc., and auditor
i. Felony to do so
5. SEC 10K Review- SEC must do comprehensive review of a company’s 10K filings AT LEAST every 3 yrs
(if not sooner). SEC must consider the companies with the LARGEST market capitalization (contrary to
previous SEC approach, which let giants like Enron slide while focusing on nickel-and-dime operations).
6. MANAGEMENT IS RESPONSIBLE FOR MANAGEMENT’S REPRESENTATIONS TO THE PUBLIC
a. Abuse: CEOs would not read ’34 Act reports (SEC Edgar Filings) for accuracy
i. ’33 Act provided personal liability for directors and signatories under § 11 for any misleading
statements of material fact in a Registration Statement
ii. ’34 Act DIDN’T originally provide personal liability for misleading statements of material fact in ’34
Act reports
b. Response: NOW CEOs/CFOs personally responsible for all material presented in ’34 Act Reports
i. CEOs and CFOs must certify each annual and quarterly report for whether:
1. They MUST read the report;
2. Based on their knowledge, report does not contain any misleading sttmt of material fact; and
3. Based on their knowledge, financial statements fairly report in all material respects the
reporting company’s financial status
ii. Must also certify personally that they are responsible for:
1. Establishing and maintaining internal controls;
2. They they’ve designed such internal controls to insure that material info related to company is
made known to them during the period, and
3. That they’ve evaluated effectiveness of such control as of 90 days prior to publication of report
a. And presented the conclusions of the effectiveness of the reports
b. Disclose deficiencies in the controls to audit committee, material or not material
7. Mandatory Disgorgement of Ill-Gotten Funds §304- BONUSES
a. CEOs and CFOs who make bonuses by misleading public must disgorge ill-gotten funds w/in 12 mos.
8. §306 Insider Trading during black out periods
a. Prior to announcement of the earnings, employee pension or benefit plans cannot trade b/c 10 days
before the earnings come out people know what earnings are going to be like. Likewise senior
management can’t trade during the period.
60
9. §402 – Special Purpose Vehicles & Loans- offshore subsidiaries must appear on parent co’s consolidated
financial statements even if GAAP does not so require
a. It is unlawful for any public company to lend money to officers or directors. IN the past, major
corporations would issue loans to D&O that were not reported as compensation because they were a
loan, and then later forgive the loans. There are some exceptions to this Rule.
10. §403 – 48 Hour Requirement- Officers/directors have to report their trades in the issuer’s securities to the
SEC must be reported within 48 hours so that it will be viewable on the SEC website within 72 hours.
11. Mandatory Reporting of all Material “Off-Balance Sheet Transactions”a. Reporting Companies MUST report all material off-balance sheet transactions, even if not required
under GAAP; off shore subsidiaries
12. SEC Must Review Filings for Fraudsters
a. SEC must review every 5 years the corporate filings of certain Reporting Companies:
i. That have made material misstatements on financials in the past
ii. Whose stock prices have experienced substantial volatility
iii. With large market capitalization
iv. Whose activities affect a material sector of the economy
13. Reporting Companies Must Disclose Material Developments on a Real-Time Basis
a. Cannot wait until upcoming 10-K, 10-Q, or monthly 8-K
i. Makes additional 8-K press releases a reporting requirement
14. Analysts who Write Analyst Reports Must be Free from Conflicts of Interest
a. There must be absolute analyst independence
i. Has to be a wall between the analyst side and the reporting company
b. Protects objectivity and independence of analysts’ research reports ultimately intended for the public
i. Restricts pre-publication clearance approval for research reports
ii. Full disclosure of how much analysts get paid by the brokerage to write the report
iii. Analysts CANNOT get bonuses or tie their salary to investment banking fees
iv. Anti-retaliation protection for issuing negative reports
15. Statute of Limitations
a. Sarbanes-Oxley added 2/5 SOL to ’34 Act
i. 2 years from personal discovery of ’34 Act violation, and in any event, 5 years from occurrence of
’34 Act violation
16. Also requires every securitor to retain at least 5% of the risk of securitizations
61
11/13/17 Class 12
DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT OF 2010
1. Congress’s reaction to financial industry collapse of 2008
2. FINANCIAL STABILITY OVERSIGHT COUNSEL (FSOC)
a. One governmental body to oversee ALL alphabet soup agencies & economy/ fin institutions
i. Chaired by secretary of Treasury
ii. Voting members are heads of Treasury, Federal Reserve, Office of Comptroller of Currency (OCC),
Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC),
Federal Deposit Insurance Corporation (FDIC), Federal Housing Finance Agency (FHFA), National
Credit Union Administration, Consumer Financial Protection Bureau (CFPB), and one independent
member with insurance expertise
b. Purpose: To identify risks regarding interconnectivity of financial system; limit expectation of bailouts
c. Duties:
i. Collect information and access risk
ii. Monitor financial services market and identify potential & emerging threats
iii. Facilitate information-sharing between member agencies
iv. Annual testimony to Congress regarding the state of financial services
3. VOLCKER RULE
a. Prohibits banking entities from trading securities with depositors’ money
b. Prohibits banking entities from engaging in proprietary trading (firm’s own money to trade)
c. Prohibits banking entities from acquiring interests in hedge funds
i. Named after Paul Volcker, former head of the Federal Reserve Board
d. Problem addressed:
i. Diverting dollars that can be used for loans and mortgages, which would benefit the economy
1. Secondary market trading does not really help the economy
2. The banking world should not be connected with the securities world
a. If one fails, they both fail!!! This happened in 2008
4. TROUBLED ASSET RELIEF PROGRAM (TARP)
a. Saved AIG, which had sold credit protection to institutional investors, from worthless mortgagebacked securities on investors’ balance sheets
i. If there are no willing buyers, the asset value is ZERO
ii. TARP was basically the federal government stepping in and saying it would buy the interest in the
worthless MBS holdings This created value and propped up the investors’ balance sheets
5. NO MORE BAILOUTS
a. Dodd-Frank prohibits government bailouts
i. No more “too big to fail”
6. Other Provisions of Dodd Frank
a. Geographic diversity of mortgage
62
b. Credit rating agenciesc. Regulating of swaps
d. Fiduciary standards for brokers & dealers
INVESTMENT COMPANY ACT OF 1940
1. Called the ’40 Act – issue was pooled investments mutual fund, ‘40 Act Regulates Mutual Funds
2. A mutual fund is a securitization of securities (MF’s where wealth of America is)
a. Issuer takes investors’ money and, instead of making scotch or growing orange trees, it invests in
securities
3. TWO Fundamental Purposes
a. To protect the public, the vast amount of whose money is invested in mutual funds from shady MFs
b. To protect the market, b/c mutual funds control so much capital that their actions can cripple the mkt
i. If fidelity sold its stock tmrw, the market would crash
4. What’s an Investment Company (aka MF)?
a. § 3(a)(1)
i. Any issuer which
Subjective Test
1. (A) Any issuer who is or holds itself out to be engaged primarily in the business of investing,
reinvesting, or trading in securities (Fidelity)
2. (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the
installment type, or has been engaged in such business and has any such certificate outstanding;
OR
Objective Test (40% Test)
3. (C) An issuer that is engaged in the business of investing, reinvesting, owning, holding, or
trading in securities AND, in fact, owns (not trades) securities (other than gov’t bonds)
exceeding 40% of the total assets.”
EXEMPTIONS
1. Operating Company Exemption
a. Notwithstanding the 40% test and maybe the subjective test, this says I am not an investment company
if I am an issuer who is PRIMARILY engaged directly in a business other than investing, reinvesting,
holding or trading, or through wholly owned subsidiaries.
i. If the issuer meets the Objective (40%) Test, the burden shifts to the issuer to prove to the SEC that
the issuer is actually an Operating Company
ii. NOTE – Holding Companies can be Operating Companies
1. E.g. Citigroup. It is a holding company w/ 100% securities of its subsidiaries, but its 3
subsidiaries (Citibank, Travelers, and Morgan Stanley) are all operating companies, and
Citigroup operates through its subsidiaries TF not an Citigroup is not an IC
2. Transient Company Exemption
a. Rule § 3(a)(2)
i. Any issuer that was previously an operating company that, due to a temporary business
occurrence, has invested money in securities is NOT an Investment Company
63
1. May be relied upon for up to 1 year, and can only be used once in a 3-year period
3. “De Minimis” Exemption - § 3(c)(1)
a. § 3(c)(1)
i. Any issuer whose outstanding securities are owned by 100 persons or less AND is not making or
does not make a public offering of its securities is NOT an Investment Company
1. The Investment Club of the Beardstown Ladies not an IC
2. PASS THE OBJECTIVE TEST BUT Congress said that they didn’t want to regulate groups of
old ladies getting together and investing their money (too small) §3(c)(1).
a. Includes venture funds
b. Basically Hedge Funds
i. Totally unregulated “little” investment companies
ii. Even if you have $2B in securities, if you limit yourself to 100 investors, you can issue an offering of
securities via R506 to raise unlimited capital w/o a public offering (no dollar limit)
iii. OR even if you have $2B in securities, if you limit yourself to 500 2000 investors (§12 Reporting) if
they are all Qualified Purchasers (see below), you can issue an offering of securities via R506 to
raise unlimited capital w/o a public offering (no dollar limit)
iv. Private Equity Fund – also uses §3(c)(7) like hedge funds – an operating company.
v. Venture Fund – also uses §3(c)(7) like hedge funds – early stage investor in start-ups (front the cash
and get out quick).
c. § 3(c)(1): Number of Investors in a Hedge Fund
i. 100 investors max ONLY want extremely wealthy people. BUT NOTE ENTITIES CAN BE
PEOPLE. COMPARE TO doing R506 w/ 35 purchasers as long as they are sophisticated and not
wealthy = waste of a spot. OR do a 4(a)(2) sophisticated
ii. No formal $$ req, for investors, but since limited to 100ppl, each slot is sacred.
iii. Hedge Fund Manager- lucrative position, 2/20 fee – 2% of AUM, and 20% of profit
1. Illegal for public company (Fidelity) to charge a performance fee b/c greater risk, greater
rewardwould get them to play the dice (Heads I win, Tails you lose)
d. Integration
i. Doctrine of Integration applies to Investment Companies
1. A hedge fund manager MAY manage more than one fund if he can avoid integration
ii. Test: Would a reasonable investor consider the funds different?
1. E.g. Hedge fund manager sets up § 3(c)(1) Fund for 100 investors. Next day set up Fund B for
100 investors.
a. If the funds are integrated, the hedge fund manager has one big fund with 200 investors, so
the fund will be subject to registration under the Investment Company Act
b. But if Fund A is a biotech fund and Fund B is an Oil and Gas Fund, or a Large Cap Fund,
etc., then a reasonable investor would consider these different. No integration.
4. Qualified Purchaser Exemption - § 3(c)(7) – 1996
a. INTENDED TO EXEMPT HEDGE FUNDS FROM ’40 ACT (passed in 1996)
64
b. Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of
acquisition, were “Qualified Purchasers,” and which does not make a public offering, is NOT an
Investment Company
i. Qualified Purchaser - § 2(a)(51)
1. Any natural person who owns, individually or with a spouse, $5,000,000 or more in securities
investments (not in assets or net worth); or
2. Any institution with at least $25,000,000 in investments
ii. NO LIMIT on number of investors
1. Therefore, NOT subject to integration doctrine
2. BUT RECALL § 12 of the ’34 Act
a. Puts an effective limit on number of investors
i. So, if a hedge fund manager under § 3(c)(7) wants to avoid registration under ’34 Act, it
cannot have more than 2,000 investors (or more than 500 non-accredited investors)
iii. Moreover, RECALL Rule 506(c)
1. Hedge funds that raise capital through Rule 506 nonpublic offerings CAN engage in general
solicitation
c. Non-Integration
i. § 3(c)(7)(E)
1. SEC will NOT integrate § 3(c)(1) and a § 3(c)(7) funds with same investment strategy for
purpose of figuring out whether § 3(c)(1) fund has more than 100 investors or whether a §
3(c)(7) fund’s securities were owned by non-QPs at time of acquisition
a. So, “clone funds” are allowed
11/20/17 Class 13
STATE BLUE SKY LAWS
1. Kansas case: Judge said “securities were backed by nothing more tangible than the clear, blue sky”
2. Every state has its own securities laws, including D.C., Puerto Rico, Guam, etc.
3. Previously had to reg. in each state you wanted to sell in
4. NATIONAL SECURITIES MARKETS IMPROVEMENTS ACT OF 1996 (NSMIA)
a. Created new definition called “Covered Securities” need only register (aka comply w/ §5)
i. Securities listed on NYSE, NASDAQ, or other national exchange (§5)
ii. Securities issued by Registered Investment Company
iii. Securities offered pursuant to Rule 506 of Reg D
b. Federal preemption of state securities laws with respect to Covered Securities
i. But states MAY require issuers to complete a “Notice Filing” whenever the issuer offers a Covered
Security in that state
1. Notice Filings
a. Non-substantive
b. Merely provide notice and allow states to collect a filing fee (Jalil says extortion!)
c. Non-Covered Securities
i. E.g. Those offered under Reg A, Crowdfunding, or another § 4(a)(2) exemption, 505, 504 etc.
1. MUST comply with BOTH federal and state securities laws
65
d. Merit Review (SEC does not have merit review)
i. SEC- prospectus: readable, 5 year financials, ages… (no verification of accuracy)
ii. Non-Covered Securities
1. Most states have discretion to apply merit review to securities offerings (say no to bad deals)
a. If a state does not like a security, it can decline to allow company to sell the security in state
i. Company was contest the merit review and provide changes to the state’s liking to get
the securities issued
b. States can also RESTRICT to whom the securities may be sold
i. E.g. You can only sell to people who have a net worth of $100,000,000 or more
c. Dilution/Accretion – how many shares insiders get (and at what price) and same for SHs.
i. SEC ONLY requires disclosure of dilution/accretion; don’t care what the actual rate is.
ii. States can judge the rate of dilution (via merit review) and, if they don’t like it, then they
can say that offering won’t happen in that state. Comes into play for Reg. A, __, 504, 505,
BUT NOT 506 or Section 5.
iii. Can also introduce K provisions, such as that they don’t like the rate of dilution but will
permit it if insiders don’t sell their shares for 2 years (as an example).
iii. Covered Securities
1. ’33 Act § 5 does NOT grant the commission Merit Review
a. Commission cannot say that security is a bad deal; Can only review for full disclosure § 5
TYPES OF INVESTMENT COMPANIES
1. Rule 22c-1
a. “Forward Pricing Rule”
i. Requires funds to sell and redeem fund shares at a price based on current Net Asset Value (NAV)
next computed after receipt of an order to buy or redeem
1. Requires that funds calculate their NAV at least once a day
a. Most funds calculate NAV when major US stock exchanges close at 4pm EST
ii. E.g. If I call at 3:59pm, I get the 4pm NAV price for that day
iii. E.g. If I call at 4:01pm, I get the 4pm NAV price for the next business day
2. UNIT INVESTMENT TRUST (“UIT”)
a. Trust with a trustee (sponsor) who manages a Static Portfolio (pool of investments will not and may
not change, mkt for UITs is huge) & Issues redeemable securities
i. In the disclosure and registration, you know exactly which securities are going to be bought, the
amount of securities, and they cannot change until the Trust ends
1. Usually 30 years
b. The UIT completes a ’33 Act § 5 issue, files registration statement with effective disclosure
c. Usually the securities are BONDS
i. Give off interest, investors get a check every month for interest
ii. Inversely Priced
1. As the market interest rate goes up, the price/value of the bond goes down
2. Face amount is irrelevant, what is relevant is the amt received in interest
66
d. Every UIT MUST issue redeemable securities
i. Redeemable at any time by the holder
1. Must be redeemed at NAV (net asset value) pursuant to Rule 22c-1 (see above)
a. Must pull out the NAV once a day- UIT will say to SEC that we get one withdrawals every 6
month, it costs too much to pull errday, so SEC
b. ALL UITS are based on Forward Pricing- order goes in and you are committed, and the
future 4pm is the price you will get when you settle. You don’t know what the price is until
4pm. If you call at 4:01 on Monday, you get the Tuesday 4pm price. All securities for a UIT
are redeemed at the same price, the price at the end of the closing day if before 4pm
e. NOTE – This is where retired people who can’t take risk put money- usually Class A debt security
that pay off interest each month, and there is safety in it, so they can live on the interest income.
f. UIT does NOT have a board of directors, corporate officers, or investment advisors to render advice
3. OPEN-END MANAGEMENT COMPANY
a. A “plain vanilla” mutual fund, Fidelity
b. Has a structure (either corporate, LLC, or LP – probably not a Trust)
i. Manager, contractor, investors
c. Completes a ’33 Act § 5 issue, files registration statement, etc.
d. Manages Portfolio on a real-time basis
i. Buying and selling all over the place; playing the market
ii. Paid in basis points
e. MUST issue redeemable securities, just like UITs
i. Must be redeemed at NAV pursuant to Rule 22c-1, just like UITs
1. Based on Forward Pricing
f. Management MUST maintain the fund to meet redemption requests
i. They might have to sell stock at a price at which they would normally not sell, but buy
ii. Cannot blame an Open-End Management Fund for panic-selling, because they must meet
redemption requests
g. DOES NOT TRADE on the After-Market
i. No reason to
h. Compensation
i. Investment Co - % of assets only; (1% for open end)
ii. Hedge Fund - % of assets + % profits. Usually 2/20. 2 PERCENT AUM (ASSET UNDER
MANGAMENT).
4. CLOSED-END MANAGEMENT FUNDS
a. Completes a ’33 Act § 5 issue, with the works
b. Manages Portfolio on a real-time basis
i. Buying and selling all over the place
c. Difference: MAY NOT issue Redeemable Securities
i. No liquidity concerns, so manager can pursue long-term strategies
ii. So how do Investors get out?
1. Sell in the After-Market (NYSE or NASDAQ)
a. Three numbers given in the closed-end after-market:
i. NAV- base line
ii. Bid Price
67
iii. Ask Price
THERE IS NO REGISTERING in 33
UNDER 44 Act you register
UNDER 40 you register investment company
MANAGEMENT ’40 ACT PROVISIONS
1. Investment Company managers have management contracts with the Funds they manage
2. Under the ’40 Act, managers are PROHIBITED from taking % of profit of an investment company because
it would promote risk-taking- But hedge fund managers are allowed to take % of profit (usually 20%)
3. § 6(c) of the ’40 Act
a. SEC may waive any provision it wishes
i. If application of any part of the ’40 Act doesn’t make sense, the SEC may issue an “exemptive
order” exempting that provision
ii. E.g. If a UIT hasn’t gotten a redemption request in 2 years, and starts to pull the NAV price twice a
month instead of every day, the SEC will likely grant them an exception under § 6(c)
4. § 7 of the ’40 Act
a. Requires Investment Companies to register with SEC
5. § 8 of the ’40 Act
a. Provides starting point for registration process
i. Forward-Looking Statements
1. Investment Company prospectuses may, with proper disclosure, make forward-looking
projections.
a. Requirements:
i. Must disclose assumptions
ii. Must state “Past performance is no guarantee of future performance”
b. To register with the SEC, you MUST send a combined filing to the SEC
i. File a registration statement under § 5 of the ’33 Act, AND
ii. File under ’40 Act to register the Fund itself
1. Compare with § 12 of the ’34 Act, where the class of securities is registered
6. § 9 of the ’40 Act
a. A “bad party” cannot be affiliated or associated with an Investment Company
b. It shall be unlawful for anyone convicted of a felony or misdemeanor within the past 10 years in
connection with the purchase or sale of any security arising out of the person’s conduct as an
underwriter, broker, dealer, investment advisor, etc., to serve as an employee, officer, or director of a
registered Investment Company
68
7. § 10 of the ’40 Act
a. At least 60% of the board of a fund MUST be independent (see exception below)
i. Cannot be affiliated with the manager of the funds (E.g. Fidelity)
1. NOTE: Even if the managing company that has contracted with the Fund sets up the actual
Fund, the managing company does not own the Fund; the public does
b. The contract between the Fund and the manager of the fund (e.g., Fidelity) has to be re-established
(renewed) every 2 years
c. The managing company cannot be the brokerage firm, cannot control the brokerage firm, cannot sell to
the Fund, and cannot invest in the Fund
i. Everything must be arm’s length
d. EXCEPTION
i. The 60% independent director threshold need not be satisfied IF
1. The Fund is an “Open-End Management Fund” with NO “Sales Load”
a. A Sales Load is a commission. Therefore, there is no fee to get in
b. if it is an open-ended company and it does not charge a sales load (commission), then it
may have more than 40% of affiliated BoD members (bc no incentive to withdraw bc not
getting sales commission
ii. No load fund – certain boards are completely interested. Allowed – rationale is that since people
can see the NAV they can see that they are getting company. BUT the company can’t charge for
buying and selling.
Restrictions on registered investment companies
THEME is SELF-DEALING; preventing self-dealing; fraud; protect the market
● How much compensation an advisor can take. (1%?)
● Cannot purchase securities on margin to protect market b/c closed system. But hedge fund can.
o Very limited exceptions (compare: hedge funds can and do to leverage); but here, ICs are a
closed system; if trade on a margin, and everyone makes a margin call, I have no other funds to
meet that demand and will default bankruptcy
● Cannot buy or sell property to any affiliate; ONLY in the anonymous market
● Cannot have a joint trading account. Must operate independently of each other.
● Cannot sell short to protect market b/c closed system. But hedge fund can
o Long – hold asset/stock – you profit if share price goes up (normal, permissible
▪ E.g.: buy 100 shares of IBM and hope, in the long run, it goes up
o Short – sell borrowed shares – you profit if share price goes DOWN; but if stock goes up, then
need to “cover” that with your own cash (often liquidate other stocks you own);
▪ E.g.: sell 100 shares of IBM that I don’t own;
o Again, closed system; if it’s a bad short, I don’t have extra $$ to cover and would default
● Cannot own more than 3% in another investment company to prevent pyramid schemes for fees.
o E.g., cannot do fund-to-fund. Tier accumulation of advisors fee (hedge funds can do this)
● Cannot take on more debt than 300% of its assets.
● Cannot use Investment Company as an underwriter.
● Dividends are restricted to avoid Ponzi schemes. Payments must be labeled as % profits or return of
capital/equity checked by accounting firm
● Advisory contracts have to be in writing and cannot be more than 2 years in duration and must be
renegotiated by the outside directors.
69
●
●
●
●
●
Can only make a contract with a registered investment advisor under the Advisors Act.
Cannot make loans to any person (particularly officers and directors) from fund.
No regulation on what RICs can invest in…BUT they may only invest in the parameters of the strategy.
You can’t change your investment policy with a vote of the SHs.
o If it wants to call itself a Diversified Investment Company, they must have certain SEC required
diversification parameters to be able to use the word diversified.
No K may base compensation on performance.
Cannot lend money, (especially not O&D or employees). They can buy debt securities.
Restrictions on registered investment companies- LOOK AT BIG OUTLINE
8. § 12 of the ’40 Act
a. Registered Investment Companies CANNOT purchase any security on margin.
i. Unlike hedge funds, which do this all the time
ii. Can’t be debt heavy, b/c of great depression
b. Registered Investment Companies CANNOT sell short
i. Unlike hedge funds, which do this all the time
9. § 15 of the ’40 Act
a. No person can act as an investment advisor to a registered Investment Company except pursuant to a
written contract that has been approved by a majority of the outstanding voting securities of such
registered Investment Company
i. MUST be in writing
ii. MUST be approved by the Fund’s board and the shareholders
iii. MUST describe compensation to be paid
iv. Shall continue for 2 years, after which is subject to renewal at least annually either by board or
majority shareholder vote
v. Contract may be terminated at any time by board or majority shareholder vote
vi. Contract automatically terminates upon assignment
10. § 17 of the ’40 Act
a. Is unlawful for an affiliate (read RIA) to transact with registered Investment Company or to borrow
funds from registered Investment Company
11. § 19 of the ’40 Act
a. Unlawful for any registered Investment Company to pay a dividend from any source other than
earnings
i. Prohibits Ponzi schemes, which pay “dividends” with new investment money
12. Prevention of Fund Chain Schemes
a. Unlawful for any registered Investment Company to invest more than 3% of its money in another
investment Fund
i. E.g. Conartist, Inc. charges a 2% management fee for Fund A. Conartist, Inc. sets up Fund B, and
invests 100% of money from Fund A in Fund B, and charges an additional 2% management fee.
1. This is illegal
70
71
11/27/17 Class 14
INVESTMENT ADVISERS ACT OF 1940
1. Also called the “Advisers Act”- Investment Advisors are of national concern and affect the market, so the
SEC is free to regulate
2. § 2(a)(11)
a. Defines Investment Advisor
i. Anyone who gets paid to give advice—directly or through publications—on investing in or
purchasing securities, or who gets paid to issue analyses on securities
ii. aka RIA: Registered Investment Advisor
b. DOES NOT INCLUDE:
i. Banks;
1. Adequately and well-regulated by federal banking laws
ii. Lawyer, Accountant, Engineer or Teacher whose performance of such services is solely incidental to
his profession;
iii. Any broker or dealer who performance of such services is solely incidental to his business and he
receives no special compensation for it
1. E.g. Merril Lynch, which gives advice daily but is regulated by FINRA
iv. Publisher of a bona fide newspaper or business of general or regular circulation
1. NYT, WSJ; E.g. Cannot be a crafty investor who, as a one-off, puts out a newsletter about how
people should structure portfolios aka buy my newsletter guy
3. § 203(a)
a. To be an Investment Advisor, you MUST be registered (licensed) under this §
b. § 203(b)
i. Contains Exemptions
1. E.g. Solely “intrastate” Investment Advisors do not need to register
a. Regulated by state laws
2. E.g. Investment Advisor whose clients are solely insurance companies
c. No exam required; just registration
d. Generally takes 45 days to get registered
e. Must make annual filings to maintain registration
f. If RIA Manages (new Dodd-Frank numbers):
i. < $100 million, must register with the state only
ii. > $100 million, must register with SEC only; if NY or Wyoming > $25M!
1. If Investment Advisor advises a Registered Investment Company, EVEN IF AUM is less than
$100,000,000, must register with SEC- No state registration required
4. § 203(c)
a. Need to file Form ADV
i. Two Parts
1. One for the SEC
2. One you must distribute to our customers
a. Disclosure
b. Form ADV
72
i. Name and form of organization in which Investment Advisor operates;
ii. Education/business affiliations of the Investment Advisor and any officers, directors, or control
persons;
iii. Nature of business, including manner of giving advice and rendering analyses;
iv. Basis upon which Investment Advisor is compensated
1. Where registered LIMITATION: can only be compensated for % of assets of management,
NOT on the basis of profits
a. illegal for RIA to be comp’d on profts, because the temptation to reckless & speculative
5. § 205 – Performance Compensation
a. No RIA shall enter into an investment advisory contract that provides for compensation based on
share of profits or capital appreciation of funds
i. § 203(b) Exemption for Private Fund Advisors (under Dodd-Frank)
1. This is for § 3(c)(1) or § 3(c)(7) funds
2. Investment Advisor does NOT have to register (and thus can take % of profits of private fund)
so long as Investment Advisor has:
a. FEWER THAN 15 private fund clients (each fund = 1 client) AND
b. LESS THAN $150,000,000 Assets Under Management (“AUM”)
ii. Existing exempt hedge funds are grandfathered in (funds existing pre-Dodd Frank)
iii. Prohibition does NOT apply to any § 3(c)(7) funds
1. Can take performance fee for RIA
iv. If investor/customer is a Qualified Client, THEN you may take a performance fee
1. Qualified Client § 3(c)(1)
a. Someone who has a net worth of $2,000,000 (exclusive of primary residence), OR
b. Someone who is investing $1,000,000 with the RIA or the Fund
2. This provision pretty much closes § 3(c)(1) funds off to Qualified Clients only
6. § 206(3)
a. RIA cannot do any other business with client other than investment advising
i. Cannot buy from or sell to client
b. Must be full disclosure
i. Cannot misstate performance or record
73
ICO’s!!!
Bitcoin
● Digital asset
● What if there is nothing you wan to barter for Money is a medium of exchange
o Why gold as the measure? Doesn’t oxidize, corrode, rare but not that rare, increase commerce
by mining it, melts at low temperature, indestructible
o No value BUT you want it because confident that the next guy wants it
o Gov/ King makes coins (if face on it, you know it’s gold b/c if counterfeit will kill) + specified
weight and value
o Knights Templar – “banks” at castles, give you a deposit slip first paper money and ATM
▪ Next created warehouses- up until 1932 was gold standard, 1970’s off silver std.
▪ 1972- off gold std completely meaning American dollar just a piece of paper now
o New dollars created by FEDbuy back
● BITCOIN is a computer entry of money (like Citibank w/ your money)
Blockchain
● Ledger that can’t be hacked broken, disrupted b/c hides in plain site
● Thoroughbred analogy
● It is the same list EVERYWHERE w/ EVERYONE, can’t change it
● Add your money to the block blockchain
● Fundamentally disruptive data storage concept
ICO
●
Are they a security?
DERIVATIVES
1. An amount which is derived from something else
2. Hypo:
a. I think GE is going up and you think GE is going down. I’m going long, you’re going short. What if we
created a derivative?
i. Notational Amount
1. You and I make a contract. GE stock is now trading at $30. I say let’s pretend I own one million
shares. If the stock goes up $1, you pay me $1,000,000, and vice versa.
3. Hedging is a good reason to do this
a. Hypo
i. I own an industrial mozzarella company. Major component is milk. When I sell cheese, I sell it at a
fixed price. But I need to adjust the price because the value of milk might go up and down.
1. I will buy a derivative on milk.
a. Now I have my price fixed. If the price of milk goes down, I get paid the difference. If the
price goes up, I pay a difference.
4. Problem
74
a. Although this is a legitimate hedging tool, people are making fortunes establishing positions based on
nothing.
75