Contents
I. The Offering Process
4
A. Underwriters
4
B. The Offering Process
4
C. Types of Underwriting/Offerings:
4
D. Problems with the Process
4
E. Underwriters and the Securities Laws
5
F. Waiting Period and Post-Effective Period
6
II. The Registration Process
8
A. Disclosure
8
B. Disclosure and the Efficient Market Hypothesis
12
C. Self-Regulation
13
D. Regulation M
14
E. Blank Check and Penny Stock Offerings
14
III. Definitions of “Security” and “Exempted Securities”
15
A. Investment Contracts
15
B. Stock and Notes
18
C. Exempted Securities / Transactions
21
D. § 4(a)(1): Exemptions for transactions not involving issuers, underwriters, and dealers 31
IV.
Regulation of Trading in Securities
35
A. Introduction to the Securities Exchange Act
35
B. Regulation of the Securities Markets
35
C. Regulation of Broker-Dealers
40
V. Civil Liability
46
A. Introduction
46
B. § 11 Liability
48
C. § 12 Liability
52
D. § 17 Liability
54
E. Liability under §10b and 10b-5
55
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Securities Regulation – Fall 2015
I. The Offering Process
A. Underwriters
a. Underwriters are financial institutions that buy stock from an issuer and then sell
the stock to the public.
b. Why use underwriters? Reputation! The public is more likely to buy stock from a
well regarded financial institution than an upstart issuer no one’s heard of.
B. The Offering Process
a. The underwriters sell to the syndicate of broker-dealers.
b. Underwriters defray risk by lining up buyers ahead of time.
i. This is “book building” and involves “road shows” and other efforts to
promote the stock.
c. The underwriters make certain there’s a run-up in price for the IPO so that all
stock will sell on the first day of trading.
i. As a by-product, this ensures the early buyers reap a handsome return.
ii. The underwriter will take care of you if the return is less than expected –
they want to make sure they have a steady stable of buyers.
d. How do underwriters make money?
i. They buy more cheaply from the issuer, then sell at a profit. In general it’s
a 7% return.
C. Types of Underwriting/Offerings:
a. Firm Commitment: The underwriter buys all of the offered stock with the intent to
sell it all at the offering. Firm Commitment underwriters make a bigger profit than
Best Efforts underwriters.
b. Best Efforts: The underwriter does not buy the stock itself – it just promises to do
its best to sell the stock. Unsold stock is returned to the issuer. The Best Efforts
underwriter only acts as an agent to sell the stock, therefore there’s less risk and
less reward.
c. Dutch Auction: An offering that bypasses underwriters. Buyers bid to buy the
stock. The market-clearing price (the price that is sufficient to buy all the shares)
is the price of the stock.
i. Treasury bonds are sold in this way.
ii. Google did this and made a hash of it. Sometimes it’s better to defer to the
specialists – underwriters have experience dealing with the myriad
regulations.
D. Problems with the Process
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a. Securities analysts are a problem. They are biased because the investment bankers
have influence over them. For this reason, there’s a 10-to-1 ratio of buy to sell
recommendations.
b. Eliot Spitzer, New York’s solicitor general, took on the I-banks and now there’s a
wall between banks’ research and sales functions.
E. Underwriters and the Securities Laws
a. SA § 5: No interstate means can be used to sell or offer to sell a security before
registration, unless an exemption applies.
i. Can be oral, written, or otherwise. Only applies to interstate means
because Congress wouldn’t be able to regulate it otherwise.
ii. It’s also illegal to offer to buy via interstate commerce (§ 5(c))
b. SA § 4(a)(1): § 5 doesn’t apply to anyone but issuers, underwriters, or dealers.
i. Therefore, ordinary folks can sell without a registration.
c. SA § 2(a)(3): An “offer to sell” is anything that’s designed to arouse interest in
the security.
i. There is an exception for “preliminary negotiations” between issuers and
underwriters – doesn’t apply for negotiations with brokers.
ii. Why have this exception? You can’t get an IPO started without
underwriters.
iii. In the Matter of Carl M. Loeb, Rhodes & Co., et al
1. Loeb jumped the gun by putting out a press release about
impending real estate venture.
2. SEC says this is illegal because it’s intended to drum up interest in
the stock. Anything that “conditions” the market for a security is
an offer to sell.
iv. Securities Act Release No. 5180
1. Backward-looking data is OK, but forward-looking predictions are
forbidden.
a. This rule applies within 30 days of the offering.
2. An issuer can release previous business information to noninvestors, but not forward-looking predictions.
v. R. 168: a previously registered issuer can release future information as
long as it’s part of a regular report and it doesn’t mention the offering.
vi. R. 163A: can announce new product if done more than 30 days prior to
filing RS, as long as you don’t mention the offer
vii. R. 169: can communicate factual information of the same type you have
been releasing, to the same people, by employers or agent, but can’t
mention the offering (content, audience, speaker)
viii. Bangor Punta
1. You can’t identify the underwriter in a notice to the public –
otherwise it’s an offer (R. 135).
d. Reporting Companies:
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i. Any publicly traded company – stock or exchange (must register and
report)
ii. R. 12g-1: Company has >$10 million of assets, or Securities held by >
2000 people (or > 500 nonaccredited investors) or $500 million in public
float (must register and report)
iii. If you have ever sold stock subject to a registration statement (only need
to report)
iv. WKSIs are essentially exempt from § 5 because they can use shelf
registration and can release any kind of information as long as certain
conditions are met.
1. R. 405: To be a WKSI, you must be S-3 eligible and your public
float must be $700 million or more OR have $1 billion in nonconvertible securities. Public float is the value of shares in the
hands of public investors.
2. Any information can be released as long as it’s also filed with the
SEC and there’s a legend on it telling readers to read the
registration statement.
e. Broker-Dealer (When §2(a)(10) and 5(c) don’t apply):
i. R. 137: A BD not participating in the offer (not UW or selling syndicate)
can issue research reports
ii. R. 138: A broker participating in the offering can make crossover
recommendations for products not a part of the offering.
1. Analysts can also make reports about “emerging growth
companies” with impunity.
iii. R. 139: a BD participating in offer can recommend stock being issue if the
issuer files a S3 report (is a seasoned issuer [public float >$75 million])
F. Waiting Period and Post-Effective Period
1. The Waiting Period is the 20-day period between filing the registration statement and
when it takes effect.
2. The underwriters always want to “build their books” during the Waiting Period rather
than the post-effective period. Why?
a. Because they can’t set the price – selling at a specific price runs the risk of
fraud when the price changes.
i. So, they do most of their marketing before the price is set.
b. Offers to buy are only illegal in the pre-filing period. You can offer to buy
during the waiting period with no problem.
c. Only written offers to sell (i.e., prospectuses) are restricted in the waiting
period.
3. A registration becomes effective 20 days after it’s filed. Why not just go ahead and
sell after filing and before the confirmation?
a. Every amendment to the registration statement starts the 20-day waiting
period again (see § 8).
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4.
5.
6.
7.
8.
b. Even more important: The SEC’s seal of approval is an important selling tool
for the offering.
Why is it a problem to send out glossy advertisements during the waiting period?
a. It violates SA § 5(b)(1), which prohibits sending a prospectus unless it meets
the requirements of § 10.
i. A glossy advertisement is a prospectus per § 2(a)(10) because it’s a
written offer to sell.
ii. A § 10 prospectus must include the price. In the waiting period, before
the price is set, this is impossible.
Ten years ago, the tombstone ad (showing only the names of underwriters) and
roadshows were the only means of promoting an offering during the waiting period.
a. Today, however, the free writing privilege has been moved from the posteffective period to the waiting period.
Types of Prospectus; §2(a)(10): Written offer to sell (not oral)
a. §(5)(b)(1): cannot use a prospectus unless it meets §10 requirements
i. Applies if RS is filed
b. §10: Names and amounts of security and information about the issuer
c. R. 430: A preliminary prospectus doesn’t have the price, but it’s otherwise the
same as a regular prospectus. (authorized by §10(b))
i. It solves the § 5(b)(1) problem because it’s “deemed” a prospectus
meeting the criteria of § 10.
d. A summary prospectus goes beyond the information in a prospectus – a
reporting company can issue a summary prospectus
e. Free Writing Prospectus: A supplement to the formal prospectus.
i. A non-reporting company can send a free writing prospectus if they’ve
already sent a preliminary prospectus.
ii. A reporting company can send a free writing prospectus if the issuer
also files it with the SEC and there’s a legend telling readers where to
find a preliminary prospectus. (WKSI)
iii. Everyone can do a free writing prospectus in the waiting period. (SI)
iv. A free writing prospectus is exempt from liability under § 11, but is
still subject to the anti-fraud rules in SA § 12(a)(2).
v. Free writing can also be used during the post-effective period. §
5(b)(1) still applies, though.
A tombstone ad is a barebones ad with infromation like the names of the
underwriters, numbers of shares, etc.
a. § 2(a)(10) says that a tombstone ad is not a prospectus.
b. R. 134: An identifying statement isn’t a prospectus either.
In the old days, if they needed more time before registration took effect, issuers
would make “delaying amendments” in the form of a meaningless change (making a
comma into a semi-colon, for example) to purposely start the 20-day waiting period
again.
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a. Now, you can just file a delaying amendment for however much time you
want.
9. Also in the old day: An amendment to the price could be filed and accepted
immediately by filing at dawn the day of the offering.
a. R. 430A changes this by allowing the filing of a prospectus with a registration
statement that does not have the price. Then, two business days before selling,
you can fill in the price.
b. Must send final prospectus (or confirmation) once price info is included
10. §8: allows SEC to accelerate the effective date
11. § 5(b)(2) says it’s illegal to deliver securities or confirm sale thereof without a
prospectus complying with § 10.
a. This is a trap for the unwary because broker-dealers always had to send a
confirmation that satisfies § 10 anyway.
b. The SEC has changed this requirement – it’s mostly done away with by R.
172. This rule makes it so that “access equals delivery” and including a link to
the prospectus is enough to satisfy the requirement.
i. A free writing in the post-effective period, however, requires the
prospectus to be actually delivered—access isn’t enough. This is in
spite of R. 172.
1. Must precede or accompany it with a §10(a) final prospectus
a. Except: can use preliminary prospectus for 1st 2 days
2. Confirmation functions as prospectus
ii. The delivery obligation lasts 40 or 90 days into the post-effective
period.
c. R. 173 says that broker-dealers don’t have to send a prospectus—just a notice
that sale was pursuant to RS ie where to find prospectus.
d. R. 174 says a dealer selling the stock of a reporting company doesn’t have to
do anything.
e. R. 172: Under no circumstances does the issuer need to do anything after the
sale.
i. The logic is that no one cares about the prospectus after the transaction
– it’s just a memento at that point.
f. R. 15C(2)(8) says that a broker must send the prospectus 48 hours before
sending the confirmation (a cooling-off period for the buyer). Access does not
equal delivery in this context.
g. SEC v. Manor Nursing Home
i. Manor submitted a fraudulent prospectus.
ii. The Second Circuit held that a fraudulent prospectus doesn’t satisfy §
10 and, thus, fails § 5(b).
iii. This is a big deal because there are almost no defenses to a § 12 action
for violation of § 5(b).
1. No due diligence defense, for example.
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2. An anti-fraud action, on the other hand, would still allow for
such defenses.
iv. This case is very persuasive because it comes from the Second Circuit.
12. The JOBS Act
a. Thinking that the registration process was too expensive for smaller
companies, Congress enacted the JOBS Act which, among other things, gave
special privileges for “emerging growth companies.”
II. The Registration Process
A. Disclosure
1. Why go public?
a. Access to financing.
b. Prestige.
c. Gives you a currency in the form of a liquid market for your stock.
2. Disadvantages to going public:
a. Dealing with the disclosure system.
b. Diminished control over dividends
i. Due to market demands
c. Competitors get to know everything you’re doing.
d. It costs about $4 million on average to go public.
3. Why have securities regulation?
a. Benefit: The safe, stable securities markets decrease every public company’s cost
of raising capital.
b. Cost: Costs all involve the hugely cumbersome disclosure process.
4. Three types of companies are required to submit regular reports to the SEC:
a. Companies that have previously gone public
b. Companies whose stock is traded on a national exchange
c. Companies with more than 2,000 stockholders or more than 500 stockholders who
are non-accredited investors.
5. For a long time, the disclosure process was bifurcated. Today, it’s integrated.
a. Regulation S-K has all the rules about what goes into a registration statement.
Disclosure requirements include:
i. Description of the business.
ii. Executive compensation (included recently in Item 402)
iii. Risk factors
iv. MD&A (Item 303): A forecast of trends that affect liquidity or
profitability in the future.
1. This was a sea change for the SEC, which typically hates putting
predictions in the disclosure filings – too much risk of
overvaluation.
a. The problem with the SEC’s old approach is that investors
care about future values, not past values.
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b. Hence, now there is a requirement that projections be
disclosed.
2. Regulation S-X covers financial disclosures.
a. It requires two years’ worth of audited financial statements.
i. The SEC doesn’t have to follow GAAP.
b. The Sarbanes-Oxley Act decides what accounting standards
the SEC should use. The Public Accounting Board came
out of Sarbanes-Oxley.
b. In the Matter of Franchard Corporation
i. Item 403 of Regulation S-K requires disclosure of anything that could
result in a change in control of the company.
1. This includes cases where a controlling shareholder puts up his
stock as collateral for a loan.
ii. Under Gaines, it’s legal not to disclose bribes made on behalf of the
company.
1. Theory is that taking a bribe reflects poorly on the executive and
is, thus, material.
2. However, giving a bribe to a foreign official is just the executive
trying to help the company succeed.
iii. There’s a zone of privacy that prevents disclosures from getting too
personal (divorces, etc.).
1. Unless it bears on one of the line items, it’s in the zone of privacy.
2. For now, the law is that character disclosures aren’t required.
6. There are four categories for disclosures:
a. Well-Known Seasoned Issuers
i. S-3 eligible.
ii. $700 million in public float or $1 billion in non-convertible securities.
iii. Advantages:
1. No waiting period (§ 5(c) doesn’t apply)
2. They can shelve stock for offering later, when the time is right.
3. The logic is that there’s enough information out there about
WKSIs, so registration statements aren’t necessary.
b. Seasoned Issuers
i. S-3 eligible
ii. $500 million in public float
iii. Information in the registration statement must be updated if there’s any
material change.
1. The theory is that the information is already out there in the
marketplace.
2. Information that is incorporated by reference is considered to be
part of the registration statement.
a. A misstatement or omission included by reference is a
fraud in the registration statement for § 11 purposes.
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c. Unseasoned Issuers
i. Reporting companies that aren’t allowed to file Form S-3. They file an S1.
d. New issuers who haven’t had an IPO.
i. They also must file an S-1.
7. Shelf Registration
a. S-3 eligible companies are allowed to register for the shelf.
i. Corrolary: Stock-Option plans couldn’t exist without shelf registration.
Therefore, companies can register their stock options for the shelf even if
they’re not S-3 eligible.
b. Shelf registration serves to allow companies to issue stock later as long as they’ve
registered for the shelf.
c. The theory is that a big enough company is well-known enough that the price of
stock is efficient.
d. When issuing shelf stock, you must issue the transaction-specific information
(price, etc) as well as whatever material information that has changed.
e. You can also sell convertible stock from the shelf.
f. Underwriters don’t like shelf registration:
i. They have about a week to do all the diligence, and they’re liable under §
11 unless they’ve done done due diligence.
ii. They also get paid less than with traditional offerings.
iii. As a mitigating rule, the SEC says that underwriters can continually do
due diligence.
1. However, there’s no chance for underwriters to do this since
they’re hired a week before the offering.
2. Rule 176 further mitigates, though, by saying the SEC will take all
circumstances into account when determining if underwriters did
reasonable due diligence. This rule applies in cases when the
underwriter has done continuous due diligence on a company.
a. Why does the SEC permit such limited due diligence? Who
knows? But they don’t’ offer a lot of protection for
underwriters.
8. Forward-Looking Disclosures
a. It’s always been the case that the SEC required disclosures of impending future
bad news.
i. On the other hand, the SEC would forbid disclosure of impending good
news.
b. Projections of revenues in ’33 Act filings are protected by R. 175, which is a safe
harbor preventing lawsuits if the issuer’s projections are made in good faith and
are reasonable.
c. R. 3b-6 applies to forward-looking information in a ’34 Act filing.
d. The Private Securities Litigation Reform Act (PSLRA) protects forward-looking
information disemminated in other contexts besides SEC filings.
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i. As long as they were given out in good faith, the issuer is protected
(there’s no reasonableness requirement).
e. The SEC now requires MD&A disclosures. They reason that MD&A disclosures
aren’t forward-looking because they are based on trends seen in the present.
i. However, what else is a projection than an extrapolation based on present
information?
ii. MD&A disclosures are information on trends with an effect on liquidity
and profitability.
iii. The standard for materiality in the MD&A context is stricter than usual.
1. Information can be material for MD&A purposes that wouldn’t be
in the fraud context.
2. That means for something to be material MD&A information, it’s
something that might have an effect on liquidity and profitablity,
but not so much that a reasonable investor would necessarily want
to know about it.
9. R. 421(d): The Plain English Rule.
a. Disclosures are to be written in plain English, understandable by a layman. Such
hipocrisy from the SEC!
10. Sarbanes-Oxley Act of 2002
a. A reaction to the Enron and WorldCom debacles of the early 2000s, SarbanesOxley intensified disclosure requirements.
i. Enron did some things that were intensely misleading, yet were
completely legal, including off-balance sheet transactions.
ii. Another was derivative contracts whose values were over-estimated on
their balance sheets.
b. So, the SEC changed its rules regarding current events reporting on Form 8-K.
i. Issuers now must disclose important events more quickly—sometimes
within two days.
c. S-Ox also requires CEOs and CFOs to sign and certify that financial statements
were subject to adequate internal controls.
i. This is a huge increase in potential liability.
ii. This doesn’t really impact executives’ willingness to become CEO or CFO
because the compensation is also enormous.
1. Therefore, there isn’t much social cost to the new requirement.
However, the worst of what the Enron CEO and CFO did was
already illegal, so there may not be that much more of a deterrent.
d. S-Ox also requires “real time” disclosure of material changes (§ 409 of the S-Ox
Act).
e. Off-balance sheet transactions have to be disclosed if they could potentially
decrease net value of the issuer (§ 401 of the S-Ox Act).
f. S-Ox’s biggest new requirement: The Internal Controls Report (§ 404) required in
Form 10-K.
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i. The report must be audited by an accounting firm. Companies must now
spend a fortune on auditors.
ii. However, Emerging Growth Companies (those companies with less than
$1 billion in annual revenue) are exempt from this requirement.
11. R. 477 allows issuers to withdraw a registration statement.
a. This is a big deal because, previously, the SEC didn’t want issuers ginning up
interest in the stock pursuant to the registration statement, but then doing some
other kind of selling that’s exempt from SEC registration.
b. The SEC can object within 15 days of the withdrawal request and prevent the
withdrawal.
B. Disclosure and the Efficient Market Hypothesis
1. Overview: The idea is that public information is reflected in stock prices.
a. There is an allocative efficiency to the market, therefore the stock’s price reflects
its value as an investment.
2. Three forms of the Efficient Market Hypothesis:
a. Weak: Past trends in price are already incorporated in the present price.
Information on past prices is readily and costlessly available. It’s already
incorporated. Therefore, you can’t make any money analyzing past stock prices.
i. Studies overwhelmingly show this is correct.
b. Semi-Strong: All publicly available information (not just price) has been
incorporated in the stock price. Therefore, you can’t make any money by trading
on public information.
i. Arguments for this proposition:
1. The securities regulation system of mandatory disclosure enables
this—every material fact is out there and it’s all incorporated in the
price.
2. Studies have shownt hat the market almost instantaneously
incorporates public information.
ii. Argument against: Investors aren’t always rational. See, e.g., status quo
bias, overconfidence, confirmation bias, etc.
1. The market crash of October 1987 was an irrational event—no
negative information should have prompted it. It was caused by
computer trading programs and panic.
2. When the market behaves irrationally, you actually can make
money based on past prices.
3. Efficiency paradox: Investors want a return, but if the market is
efficient, then the price of a stock is exactly its value.
4. There is a lot of evidence that the semi-strong efficient market
hypothesis is correct, but there are exceptions within some
windows of time.
c. Strong: Even inside information is incorporated in the price.
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i. Argument for: Inside information isn’t completely inside—insiders have
to report their trades to the SEC).
1. Insiders have a strong tendency to make money when they trade
their own stock.
a. This could mean there’s insider trading going on. Or it
could just mean they know when not to trade based on
inside information (which is legal).
b. Also, it could be that insiders are just better at analyzing
public information than the general public.
3. Many believe that the system of mandatory disclosures is what enables the semi-strong
theory of market efficiency.
a. Query: What would be different if there were no such system?
C. Self-Regulation
1. FINRA
a. Every securities dealer must be a part of an association of self-regulating
securities dealers.
i. There has only ever been one such association. Formerly, it was the
National Association of Dealers. Now, it’s FINRA.
b. FINRA is registered with the SEC and is completely under the SEC’s jurisdiction.
The SEC gets final say on FINRA’s rules.
c. FINRA puts out ethical guidelines and technical rules.
i. It’s ethical misconduct for broker-dealers to overcharge clients, for
example.
ii. Also, brokers can’t take a commisssion over a certain percentage.
iii. FINRA rules don’t have a private right of action – no private enforcement
by third parties.
iv. FINRA doesn’t allow raising a stock’s offering rate beyond what the
registration statement says.
v. Also, you can’t withhold shares from the public—all the shares must be
sold to the public if the registration statement says they’ll do it.
1. Underwriters don’t want to say they’re holding back stock in the
registration statement.
2. Basically, this means that an underwriter can’t profit from an IPO
beyond the spread of hte othering rate and the initial market price.
vi. Underwriters CAN, however, sell specifically to its favorite clients.
1. They can’t sell to themselves, insiders, or affiliates, but tyhey can
sell to their best outside clients.
vii. “Spinning” is illegal – you can’t allocate hot issue shares to other issuers
in exchange for past or future business.
1. “Spinning” by implicastion – with no binding agreement – is
perfectly legal, however.
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D. Regulation M
1. In general, Regulation M prevents you from buying what you’re selling.
a. Underwriters, broker-dealers, and affiliated purchasers can’t buy the securities
whose offering they’ve participated in until after the “restricted period.”
i. For stocks with trading volume of $100,000 or more and the issuer has
$20 million in public float, the restricted period starts one business day
before designation of the offering price.
ii. Otherwise, the restricted period begins on the later of five business days
prior to the determination of the offering price or the date on which the
person becomes a distribution participant.
b. Stabilization, however, is legal. For a specific “stabilization period,” the
underwriters can buy back stock for the purchase price.
i. This sets an artificial floor for the price of the stock.
ii. It’s not fraud because the stabilization efforts are disclosed in the
registration statement. (price manipulation must involve some
nondisclosure)
E. Blank Check and Penny Stock Offerings
1. A blank check offering is when investors give money to an entity with no business plan.
a. The fact that the SEC regulates these is controversial because, theoretically, the
SEC can’t make merits-based regulations (i.e., fairness judgments that are the
purview of state regulators).
2. The SEC makes blank check issuers put the money from the offering in escrow until the
issuer tells the investors what they plan to do with the money.
a. Allow recission to anyone who wants it (bc of no business plan)
b. Ragazzo doesn’t think this is a merits-based regulation.
3. Funds raised from penny stock offerings must also be put in escrow until certain
conditions are met.
III. Definitions of “Security” and “Exempted Securities”
A. Securities
a.
b.
c.
d.
Cannot offer to sell or buy until filing Registration Statement
Cannot sell w/o accompanying prospectus during waiting period
Cannot sell stock until Registration Statement is effective
Criminal liability for Security fraud if it’s a security
i. Also easier to win civil fraud
e. SEC can only regulate investment if it’s a security
B. Investment Contracts
1. Why does it matter whether something is a security?
a. There are a ton of special rules that apply if it’s a security.
b. Securities Acts always start with a definition of what a security is.
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2. If an asset doesn’t fit the enumerated laundry list of items in § 2(a)(1) of the Securities
Act, then the court must decide if it’s still an “investment contract,” the catch-all at the
end of the list.
3. SEC v. W.J. Howey Co.
a. The SEC brought a civil action against Howey, claiming it violated § 5(a) with its
offer of plots of land to be cultivated by Howey for orange planting.
i. This is only a valid cause of action if the land/service/deed package sold
by Howey is a security
b. Howey sold deeds to investors and then offered service contracts wherein the
management company cultivated and sold the oranges, then the investor gets a pro
rata portion of the profit.
c. The Court devises a four-element test to determine whether something that
doesn’t fit within the § 2(a)(1) qualifies as an “investment contract,” the garbage
can provision at the end.
i. Elements:
1. Investment of money;
2. Common enterprise;
3. Expectation of profit; and
4. Solely based on the efforts of others (not incentivized to
investigate & someone else manages money)
a. “Solely” is read to mean “predominantly” to avoid an
absurdly large loophole.
ii. “Common enterprise” is satisfied if there’s “horizontal commonality” or
“vertical commonality”
1. Horizontal Commonality: All the investors profit or lose in the
same proportion. (stand in same boat; shows common enterprise)
a. The best example of this is buying stock in a corporation.
2. Vertical Commonality: The investors’ fortunes align with the
issuer (recognized in some courts)
a. Strict Vertical Commonality: Fortunes of the investor are
linked to the fortunes of the promoter or a third party.
i. Accepted by majority
b. Broad Vertical Commonality: Fortunes of the investor are
linked to the efforts of the promoter or third party.
iii. Why is commonality important?
1. There’s a huge free rider/collective action problem because if one
person bears all the cost for due diligence, etc., they only get a
small fraction of the benefit while bearing 100% of the cost.
a. On the other hand, if you’re buying the whole business, you
have every incentive to make an informed investment.
d. The court finds that the orange scheme is an investment contract and, therefore, a
security because it fit all four elements of the test.
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i. The people who bought land, but no service contract, did not purchase a
security. However, they were still offered a security without registration in
violation of § 5(c).
4. SEC v. Life Partners, Inc.
a. LPI was selling the life insurance policies of AIDS patients to investors.
b. LPI made money on this by discounting the payout depending on the net present
value of the payout.
i. So, LPI made the most profit if the patient died quickly.
c. Viatical settlements (the name for this type of arrangement) have been a very poor
investment because medical advances have allowed AIDS patients to live much
longer than expected.
d. The court holds that the viatical settlement in this case isn’t a security.
i. This is because the profit doesn’t come from the efforts of others.
ii. However, isn’t LPI making all the efforts at picking out the patients and
policies to sell?
1. The court explains this by saying there were no post-purchase
efforts—compare to the case where selling and storing silver was
not a security.
2. This is very wrong, according to Ragazzo.
a. Some courts say if you create a secondary market it’s a sec
b. Minority of courts agree with this case
5. SEC v. Koscot Interplanetary, Inc.
a. The court says that the pyramid selling scheme is a security because, in addition
to the other elements, there is vertical commonality.
b. Broad vertical commonality is enough to satisfy the “common enterprise” prong.
i. Conflates prong 2 and 4
ii. Minority of courts disagree
c. Is there profit predominantly through the efforts of others?
i. It’s a security because it’s a fraud—money comes from new investors, not
selling products.
ii. Therefore, it’s the promoters’ efforts bringing in new investors that yields
profits for the previous investors.
6. SEC v. Edwards
a. SEC: The sale-and-leaseback payphone scheme was a security because ETS
violated §§ 5(a) and (c), as well as securities fraud provisions.
b. Edwards: Not a security because there’s a fixed return. Therefore, it’s not “profit
based on efforts of others.”
c. Court: There’s no reason to make a distinction between fixed and variable profits,
and every other “investment contract” element is there, so it’s a security.
i. The lower court read the Forman decision to mean that profit is either
capital appreciation or participation in earnings, therefore it can’t be a
fixed return.
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ii. However, this can’t be right because preferred stock is definitely a
securitiy and it pays a fixed rate of return.
iii. Daniel is inapposite because the employees’ return doesn’t depend on the
success of the investment, just in the solvency of the company, which
must pay regardless of the plan’s success.
iv. Forman also doesn’t apply because the capital appreciation/earnings
participation requirement is for a finding of stock, not an investment
contract.
d. You could actually argue the scheme was a loan from the investor to the issuer, so
it may have qualified as a note even if it hadn’t been an investment contract.
e. Commonality element:
i. There is definitely broad vertical commonality because the promoters are
running the payphone scheme.
ii. You could say there’s also horizontal commonality because the whole
payphone scheme has to be successful to get the payout.
1. You won’t get your 14% return if the entire scheme isn’t
successful.
2. Your payout isn’t just from your individual payphone.
7. United Housing Foundation, Inc. v. Forman
a. Riverbay issues “stock,” purchase of which is a prerequisite for living in a
housing community.
b. Stock holders can’t sell the stock for more than the purchase price.
i. The only benefit of owning the stock was the right to live in the housing
project.
ii. The stock sale was to raise money for the construction of the housing
project.
c. Tenants sued, alleging breach of the anti-fraud provisions of the Securities Act
and Securities Exchange Act.
d. Court holds it’s not a security because it’s not stock and it’s not an investment
contract.
i. There’s no liquidity (alienable, pledge, sell for appreciated value), no
proportional voting share, and no dividends (essential traits of stock),
therefore it’s not stock.
1. Also, the voting was divvied up at one vote per unit, as opposed to
being divided proportionally based on ownership of shares as with
normal stock.
ii. It’s not an investment contract, either, because there was no expectation of
profit, therefore it’s not an investment.
8. Int’l Brotherhood of Teamsters, Chauffers, Warehousemen and Helpers of America v.
Daniel
a. Question: Is a compulsory pension an investment contract?
b. Employees didn’t choose the investment and didn’t put up their own cash.
c. Lower courts believed the pensions were investment contracts.
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i. They also said the employees voluntarily invested because they chose to
work there.
d. The SCOTUS finds it’s not an investment contract.
i. There must be an “investment of money.”
1. This requires “specific consideration in return for a separable
financial interest with the characteristics of a security.”
ii. The “profits” element is also unmet because it consists of employer
contributions, not interest. Also, it’s from the efforts of the employee to
meet the vesting requirements.
iii. Also, ERISA already deals with pensions in great detail, so there’s no
need to extend securities regulation to cover them.
e. Ragazzo thinks the SCOTUS’s reasoning is suspect: In a real economic sense, the
employees are contributing money to the pension—they’ve accepted the pension
in lieu of cash payment.
i. However, their only interest in the pension fund is the solvency of the
company, they don’t benefit or suffer beyond whether or not the company
can repay its debts. This cuts against the profit expectation such that it’s
deferred compensation rather than an investment.
9. Securities Act Release No. 5347
a. Condominium contracts are securities if they come with service contracts from
which the buyer expects to profit.
i. Maintenance doesn’t count as “efforts of others.”
10. Steinhardt Group Inc. v. Citicorp
a. This is a fraud action involving the securitization of delinquent residential
mortgage loans and real estate.
b. The scheme involved creation of a limited partnership that would issue
nonrecourse bonds and equity securities in the form of partnership interests.
i. CSI would underwrite a public offering of bonds to pay off bridge
financing for Bristol (the limited partnership).
ii. Investors in Bristol’s partnership interests were to profit from the pooled
mortgage loans.
c. Steinhardt alleged that Citi used false data obtained from compromised brokers,
and that Citi concealed the inaccuracies.
d. Citi: Steinhardt had too much control over its investment for the third Howey
prong to be met.
e. The court looked to the partnership agreement for the answer.
i. Steinhardt could make, approve, and veto business plans.
ii. He could also remove and replace the managing partner without notice.
iii. More than just negative powers
f. This level of control was deemed too much for the investment to meet the Howey
standard for an investment contract.
C. Stock and Notes
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1. Stock
a. Stock is in the enumerated list in § 2(a)(1). Not all things called “stock” are
actually stock, however, as the United Housing Foundation case showed.
b. Landreth Timber Company v. Landreth
i. Question: Is a sale of all a company’s stock a security?
ii. Facts:
1. Fire damaged a sawmill before stock was sold—the issuer had
promised buyers it would be fixed.
2. Dennis bought the stock after an audit, but the repairs cost more
than anticipated and the company went bankrupt.
3. Petitioner then sued for recission, alleging it had been sold an
unregistered security.
iii. Landreth: A “sale of business” isn’t a security.
iv. The court disagrees.
1. The stock had all the normal characteristics of stock (no United
Housing Foundation problem).
2. No need to look beyond those characteristics because the plain
meaning of the statute incorporates this type of stock—no need to
look to economic realities of the situation.
3. Also, the ’34 Act has lots of indications that sales to active
entrepreneurs are covered (trader offers, short swing profits, etc.).
4. Further, Landreth was going to stick around and manage the mill.
5. Policy: There are too many line-drawing problems with the
propostion that a “sale of business” isn’t a security.
a. The rule is a hard line rather than a standard, which
promotes judicial efficiency.
b. Ragazzo says, “Why not just say when there’s a sale of
100% of a business’s stock, apply the ‘sale of business’
exception?”
v. Forman “Stock Test”:
1. Right to receive dividend contingent on apportionment of profits
2. Negotiability
3. Ability to pledge
4. Voting rights based on number of shares
5. Capacity to appreciate in value
a. If satisfied and called stock – dispositive; likelihood
purchaser believed it was covered
vi. All stock is a security, unless the economic context otherwise requires
2. Notes
a. Reves v. Ernst & Young
i. The co-op sold promissory notes with a variable rate of interest to fund its
operation.
ii. The co-op went bankrupt.
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iii. Noteholders sued Ernst & Young, which audited the co-op’s financial
statements, under 10b-5.
iv. § 3(a)(10) of the ’34 Act says that a note with a maturity of more than 9
months is a security.
v. The court decides that a demand note with a maturity date of 9 months
meets the § 3(a)(10) definition of a security.
1. The reasoning is that most people hold onto the note for the regular
term even if they are able to demand their money at any point.
2. However, this isn’t the end of the discussion since not every note is
a security (e.g., a home loan).
vi. Also, the public doesn’t think of notes as being securities automatically, as
is the case with stock.
1. Depends how the note is marketed
vii. Where notes are concerned, the flush language in § 3(a), which says
“unless the context otherwise requires,” has an effect. (Note, though, that
stock is stock regardless of the context).
1. Therefore, a long-term note is a security unless the context requires
otherwise.
viii. Court applies the 2nd Cir. Family Resemblance Test.
1. It starts with a presumption that a long-term note is a security, but
the presumption is rebuttable based on:
a. Whether the issuer’s motivation is for investment or
commercial purposes.
i. Commercial purposes include cashflow problems.
Also includes money for raw materials, funding
assets, etc. Consumption purposes also will exempt
a note from security status (pay bank for time value
of money)
ii. Commercial paper exception (33 act): time you
need capital and time of sales don’t align so they
need float
1. Borrow money from sophisticated investors
and low risk
iii. Investment is for general use of the business
enterprise or to finance a substantial investment.
b. Whether the scheme of distribution is broad or narrow.
c. Whether the investors’ reasonable expectations involve
investment.
i. Court looks to how the instrument is advertised to
the offerees.
d. Whether there’s an equivalent regulatory scheme that
reduces the risk to buyers.
i. Risk reducing factors (low risk if secured)
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b. A Note about Notes
i. But! What about short-term notes?
1. The ’33 Act doesn’t exclude short-term notes (commercial paper)
from the definition of “security,” but § 3(a)(3) exempts them from
registration.
2. The SEC has always wanted to add requirements to the short-term
note exemption, such as . . .
3. It’s an open question. Who’s to say?
ii. How would the payphone scheme work out if it were a note?
1. Definitely motivated by investment potential.
2. Definitely offered to the public at large.
3. Also, definite that the buyers wanted profit and the instrument was
advertised as an investment.
4. There’s a close question as to whether there’s a satisfactory
regulatory scheme.
iii. The fourth element of the Reves test is controversial.
1. CDs have been deemed not to be securities because bank
regulations cover them. But, the goals of the banking laws are to
preserve the banking system, not to protect investors.
2. It’s also an open question whether state or foreign regulation
schemes are sufficient to meet the fourth element of Reves.
3. Also: What about non-regulatory reasons that makean investment
less risky?
3. LLCs, General Partnerships, and Limited Partnerships and Securities
a. Limited partnership interests are usually investment contracts because the limited
partners are usually passive investors.
b. In a manager-managed LLC, units are usually securities. The opposite is true for
member-managed LLCs.
c. General Partnerships:
i. Williamson doctrine holds that a general partnership interest is not a
security if you are permitted control in the agreement.
1. Contrast to Howey, in which you can still have a security even if
you’re permitted control, but don’t exercise it.
2. Are securities in Texas
D. Exempted Securities / Transactions
1. Exempted Securities – if you sale or offer without a Registration statement
a. §5(a) prevents sales before filing and §5(c) prevents sales before effective date;
§13 limitation period; Buyers can seek §12 recission
b. Excludes you from §5 requirements; still liable for §11, 12, 17, 12a-2 & 10b-5
i. §12(a)(2): can bring action, even if exempted under §3 (except §3(a)(2) &
14)
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c.
d.
e.
f.
g.
h.
i.
ii. §17: not exempted by §3 exemptions
The transaction exemptions are mostly in § 4 and the security exemptions (related
to the nature of the security) are mostly in § 3.
§3 Registration exemption: excludes you from 33 act; generally exempt from RS,
but not anti-fraud
§3(a)(2): Exempts bonds marketed by state and local governments because you
cannot prevent states from raising money
i. 34 act 15c2-12: still requires a disclosure statement
§ 3(a)(3) has a potpourri of securities, including ones issued by the federal
government, state governments, municipal authorities, and securities backed by
banks.
i. Cash Flow Exemption: current transaction with < 9-month maturity and
not to repay loan
1. SEC adds 2 requirments for exemption:
a. Low risk, high quality commercial paper, issued by
seasoned issuer
b. Not marketed to general public
2. 34 act, §3a(10): notes less than 9 months are not sec (Reves
disagrees) – discover relationship to 3a3
3. Might have an exempt 33 act security and a security exempt under
34 act
a. Might be nonexempt and exempt
b. Might have no security at all under 33 act
i. Reves – might apply to 34 act & might effect 33 act
exemption
ii. Why exempt state and local issuers?
1. For federalism reasons and also to subsidize state and local
fundraising.
a. States and municipalities have just as big risk profiles to
investors as private issuers, so they’re not exempt because
they’re less risky.
b. To regulate states and municipalities, the SEC goes through
the back door by requiring a purchase statement that is
essentially the same as a registration statement.
2. The exemption for bank-backed securities is controversial. The
idea is that banks are subject to a lot of other regulation.
§ 3(a)(4) provides exemptions for charitable organizations.
§ 3(a)(5) exempts securities from savings & loan organizations.
§ 3(a)(8) exempts insurance contracts.
i. There’s a substantial body of state regulation covering this.
ii. One view: An insurance contract under § 3(a)(8) isn’t even a security,
therefore the anti-fraud rules don’t apply, either. A contract that promises
a fixed return has been deemed not to be a security.
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j. Exempt securities are still subject to anti-fraud rules.
i. It’s a nice question whether notes meeting the § 3(a)(3) exemption are still
subject to anti-fraud provisions.
2. Transactional Exemptions
a. Only issuers get the exemption.
b. The party claiming the exemption has the burden of proof.
c. The Private Offering Exemption - § 4(a)(2)
i. What constitutes a “public” offering?
1. SEC v. Ralston Purina Co. – number and sophistication
a. Purina Factors:
i. Number of offerees & their relationship
ii. Number of units offered
iii. Size of the offering
iv. Manner of the offering
b. The idea of employee stock options is to align the interests
of employees and owners.
c. The plan was only available to “key employees.”
i. Key employees included almost all the company’s
employees.
d. $2 million (in 1970s dollars) went into this plan, so a lot of
employees bought into it.
e. Purina argues this offering is eligible for the § 4(a)(2)
exemption because it wasn’t a public offering.
f. SCOTUS rejects this argument: It’s a sufficiently large
population to where it doesn’t matter that it wasn’t offered
to the public at large. Also “public” means “unsophisticated
investors are involved.”
i. A sufficiently large pool of offerees is still “public”
for Congress’s purposes.
ii. Don’t know how business is doing and need
protection
g. The real metric is whether the offerees are sophisticated
investors. That’s the court’s reason for rejecting a plan
that’s offered to a specific population as a private offering.
i. The number of offerees is still relevant, but their
sophistication is key.
ii. An offering to one person might still be a public
offering.
iii. Likewise, an offering involving huge institutional
investors and billions of dollars could be a private
offering if there are no rubes involved.
h. The court’s formulation is so amorphous and stringent that
the best legal advice in the wake of this and Continental
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ii.
iii.
iv.
v.
vi.
Tobacco/Hill York is to not even bother with the § 4(a)(2)
exemption.
i. The consequences are immense: Rescission for one
year!
ii. Instead, use a bright line safe harbor exemption in
Regulation D.
Access to Information is a Prerequisite to Sophistication
1. Doran v. Petroleum Management Corp.
a. Eight people got the offer for limited partnership units.
b. The number of offerees—not purchasers—is what matters
for evaluating offerings.
c. Also, number of units offered, size of offering, and the
manner of offering are relevant.
d. The court remands the case to determine whether the
offerees had access to sufficient information—offerees
must both be sophisticated and have actual access to
relevant information.
i. Even with sophisticated offerees, it doesn’t mean
they count for a private offering unless they have
access to information that a sophisticated investor in
that area would want.
e. To determine if a new well will be profitable, you must
look at seismic logs.
i. Even then, there’s a 90% failure rate.
f. Types of access:
i. Insiders
1. They count as sophisticated because they
have access to the right information.
ii. Institutional investors
1. They have enough bargaining power to get
whatever information they need.
iii. People with personal relationships with the issuer
iv. People who are actually provided with information.
The entire offering is either exempt or not exempt – one bad offeree will
ruin the whole exemption.
There are two types of offerings that are exempt.
1. Offerings only to institutional investors.
2. Offerings only to friends
The draconian penalties for violating § 5(a) and the fact that it’s an
exemption based on standards, rather than rules, make it a risky
proposition.
Even when you do a § 4(a)(2) private offering, you’re subject to state regs.
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vii. However, if you do an offering pursuant to the rules promulgated under §
4(a)(2), you’re exempt from state regulations.
3. Transactional Exemptions under the Rules
a. Rule 506 – The Most Popular Exemption – Promulgated under § 4(a)(2)
i. Requirements
1. The offer must be to:
a. An unlimited number of accredited investors;
b. 35 sophisticated, non-accredited purchasers.
i. The issuer must reasonably believe they are
sophisticated.
ii. It’s purchasers, not offerees, that count.
ii. How to prove that the issuer reasonably believed they’re sophisticated?
1. Send a questionnaire investigating the offerees’ other investments,
etc. Get them on the record.
iii. The chief advantage of R. 506 is there’s no limit on the offer—you can
sell as much stock as you like.
iv. Rule 501(a): Rich people and institutional investors are accredited
investors.
v. Rule 502(d):
1. No resale of the stock sold under R. 506.
2. Non-accredited investors must get material information similar to
what’s in a registration statement.
a. The information is listed in R. 502(b).
vi. Rule 502(c): No general solicitation.
1. It’s possible to do a R. 506 offer with a general solicitation if you
take steps to ensure you only sell to accredited investors (R.
506(c)).
b. Rule 505
i. Requirements:
1. Issuer can’t be a bad actor or an investment company.
2. It must be offered to accredited investors and no more than 35 nonaccredited investors.
3. Investors must get information listed in R. 502(b) (similar to a
registration statement).
4. No resale allowed (R. 502(d)).
5. No general solicitations (R. 502(c)).
ii. Major advantage of R. 505 is that there’s no sophistication requirement.
iii. Chief disadvantage is that it’s limited to $5 million per year, including:
1. Any stock sold under a § 3(b) exemption within the last year
2. Any stock sold under R. 504
3. Any stock sold in violation of § 5.
c. Rule 504 (promulgated under § 3(b))
i. Who can use R. 504?
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1. Non-reporting companies (not subject to § 12 or § 13 of the
Exchange Act)
a. Note: A reporting company (in the Exchange Act):
i. Has stock traded on a national exchange (§ 12),
ii. Has 2,000 accredited investors and over $10 million
in assets (§ 13)
iii. Has previously filed a registration statement and
sold stock pursuant to it (§ 15(d)).
2. R. 504 is designed for small businesses to raise money.
a. On the other hand, fraud is just as rampant with small
businesses.
ii. Why use R. 504?
1. You can sell to anyone.
2. There’s no information requirement.
3. There’s no resale prohibition as long as there’s a state registration
scheme and information is given to investors.
4. No restriction on general solicitation.
5. Disadvantage of R. 504: You’re limited to an offering of $1
million, including stock sold illegally or under a § 3(b) exemption.
d. ***Make a chart of all the Rules Exemptions***
4. Integration
a. This is when two or more offerings are combined to create one big offering.
i. Integration prevents mixing and matching of exemption criteria. It makes
it so that the offerings must meet all of one of the exemption criteria.
ii. Example:
1. 1/1/2015: R.506 $100 million Build new plant Preferred
Stock
2. 2/1/2015: R. 505 $5 million Increased insurance costs Bonds
b. Aggregation is when the amounts of the offering are lumped together. Here,
there’s no aggregation problem because R. 506 is a § 4(a)(2) exemption and,
therefore, doesn’t count toward the R. 505 limit.
c. R. 502(a) has an integration requirement that applies to all the Rules exemptions.
i. 502(a) factors:
1. Same plan of financing;
2. Involves issuance of the same class of securities;
3. Sales made at or about the same time;
4. Same type of consideration;
5. Sales made for same general purpose.
ii. Integration is always a risk when two offerings are made within six
months.
5. Regulation A
a. Nobody used to use Regulation A because it essentially was a registration process
– so, what’s the difference between Reg. A and the standard registration process?
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i. Reg. A offered exemption from § 11 fraud liability, but this wasn’t much
of a perk.
ii. Also, issuers could “test the water” prior to registration—this allowed for
general solicitation to gauge interest in the offering.
iii. Also, the issuer isn’t required to become a reporting company, which is
what happens when you sell stock pursuant to a registration statement.
iv. Also, you can sell to unlimited purchasers (as opposed to 35 under Reg.
D).
b. Despite all this, no one used Reg. A, so Congress decided to allow the SEC to
make it more attractive by raising the cap from $5 million to $50 million.
c. Certain companies can’t use Reg. A:
i. Reporting companies
ii. Bad actors (under investigation or convicted)
d. Reg. A Features:
i. Issuers are required to file regular reports (only difference is that they’re
semi-annual rather than quarterly).
ii. Financial statements must be audited
iii. So, the requirements are actually pretty similar to those of a reporting
compnay.
1. The SEC must not have liked being told to increase the Reg. A
cap.
iv. Tier 2 Reg. A offerings are exempt from state regulation.
v. Also, there can’t be an investment of over 10% of the investor’s income.
vi. Integration Worry:
1. R. 251(c)(1) says a Reg. A offering can’t be integrated with a prior
sale of securities.
a. However, it’s unclear whether a Reg. D offering can be
integrated with a Reg. A offering. It’s an open question
whether R. 251(c)(1) works both ways.
2. You never want to be at the mercy of the five-factor integration
test.
3. Under Reg. D, the six-month safe harbor is only available if there
are no offerings (doesn’t matter if there were no sales). Also, each
new offer starts the 6-month clock again.
a. Reg. A is not as strict. It only requires that there be no sales
in the 6-month period.
6. R. 701 is for pension plans and stock option plans.
a. It’s a reaction to the Ralston Purina case. Issuers only have to provide
information on the plan to the offerees.
7. § 4(a)(6) Crowdfunding Exception
a. The Obama administration pushed this exception, possibly because of Obama’s
success with crowdfunding in his presidential campaigns.
28
b. The ceiling for a per-investor contribution is the greater of $2,000 or 5% of the
income of someone with income greater than or equal to $100,000.
c. The maximum amount to be raised is $1 million.
d. Policy question: Aren’t low income people deserving of more—not less—
regulatory protection?
e. To balance this out, the SEC created a negligence-based cause of action for fraud.
8. § 3(a)(11) and R. 147: Intrastate Offerings
a. The idea is that local investors will know everything that’s going on in their state.
i. The SEC hates this exemption.
b. SEC v. McDonald Investment Co.
i. McDonald, a MN company, sought funding for loans for Arizona land
development.
1. They tried an intrastate offering exemption.
ii. Courts have said that most of the proceeds of an offering must be directed
at the state to be eligible for the exemption.
iii. Rule: To get the exemption, the issuer must do most of its business in the
state and most of the proceeds must be sold in-state.
c. Busch v. Carpenter
i. An Illinois company acquired a bare-bones Utah company after the UT
company issued a § 3(a)(11) offering.
ii. The question here is whether the offering was “part of the same issue.”
1. This is determined by where the stock “comes to rest.” This is
determined by the investors’ intent.
a. Do the UT residents intend to hold or resell the stock?
i. A holding period greater than 7 months is necessary
to show investment intent.
iii. In Busch, the court gives summary judgment as to the investment intent.
1. Time is the biggest factor but, if there is a changed crimcunstance
that resulted in sale, then there is a fact issue as to intent.
2. The problem here is that now the issuer is doing all their business
in Illinois.
d. The § 3(a)(11) exemption is of dubious value because of the mushy standards that
control its application. Instead, use R. 147.
i. R. 147 is strict because the SEC doesn’t like the intrastate exemption.
ii. For R. 147 to work, you must offer only to in-state investors—doesn’t
matter if no out-of-staters were purchasers.
iii. R. 147 lays out what it means to be an in-state resident:
1. Individual must have principal residence in-state;
2. Entity must have principal office in-state.
iv. Also, to be “doing business” in a state, you must have the principal office
in the relevant state.
v. Then, there’s the 3 x 80% test:
1. 80% of revenue must be in-state.
29
2. 80% of assets must be in-state.
3. 80% of proceeds must be in-state.
vi. The investor can’t resell within 9 months. After 9 months, it’s “come to
rest” with the in-state investor.
vii. Integration Warning: This will kill your exemption because the 506
offering will involve out-of-staters and the R. 147 offering will involve
unsophisticated investors.
e. Always have an integration safe harbor – don’t take your chances with the fivefactor test.
9. Spin-Offs, Reorganizations, and Recapitalizations
a. Under the Securities Act, giving up any interest in a security for value is a sale.
i. What if it’s a warrant?
1. Warrants don’t need to be registered because they’re not
transferred for value. It’s given to shareholders without
consideration.
2. A warrant is an offer to sell common stock. The sale of common
stock itself requires registration. So, if the warrants are exercisable
immediately, you have to register the common stock
simultaneously with giving out the warrants.
ii. If you offer to sell preferred stock that can be converted to common stock,
what needs to be registered?
1. Both. The preferred stock is offered for sale, and it can be turned
into common stock, which also must be registered.
iii. Only things to be offered in the future must be registered.
iv. § 5 only prohibits offering or selling without registration. Therefore, a
stock dividend doesn’t need to be registered. It’s not a sale or an offer to
sell.
1. However, if you’re offered either stock or a cash dividend, you
must register. If the company gives you a choice, the SEC views
the transaction as an exchange of cash for stock, so it’s a sale.
a. Even though this is essentially the same as getting a stock
dividend, then selling it.
v. A company giving away stock in exchange for registering on a web site
(for free) requires registration.
1. The SEC understands this to be an exchange for value. Value is
given whether the purchaser pays something (whether or not it’s
cash) or if the issuer receives something of value (doesn’t have to
be from the purchaser herself).
vi. Suppose a 100% shareholder gives away 20% of his stock so as to create a
market for that security.
1. This, too, would require registration even though the shareholder,
not the issuer, is receiving value.
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vii. Giving up any portion of the bundle of rights associated with the security
for value counts as a sale, therefore a pledge of securities is a sale.
b. § 3(a)(9) exempts exchanges exclusively with your existing shareholders.
i. Any material change in the terms of a security is deemed to be exchanging
one security for a new one. Even if no pieces of paper change hands. This
includes changes in voting rights.
ii. A company can’t spend any money on the exchange, or else the § 3(a)(9)
exemption is lost.
1. No registration is required before an exchange covered by § 3(a)(9)
as long as no money is spent soliciting the exchange.
iii. Meaning of “exclusively” in § 3(a)(9)
1. SEC says it means two things:
a. (1) Must be offered exclusively to existing shareholders;
b. (2) The existing shareholders must exclusively give up their
securities.
i. This only applies to shareholders. The issuer may
give other kinds of consideration for their securities.
iv. Can you re-sell stock exempted under § 3(a)(9)?
1. That which you receive in an exchange takes on the character of
what you gave up.
a. If you have a restricted (i.e., non-resellable) security, what
you get in exchange is also restricted.
b. If you have freely resaleable securities, what you get in
exchange is freely resaleable.
v. Integration Problem!
1. Series A stock Series B stock
2. Series C stock Cash
3. Cash Redeem Series A Bonds
a. The same exemption will have to apply to all three
transactions if they occur in the same 6 months.
b. Transaction 2 involves selling to non-shareholders, so §
3(a)(9) won’t apply. Then § 4(a)(2) won’t apply because
the private offering safe harbor won’t apply.
c. Therefore, we must look to the 5-factor test:
i. One plan of financing?
1. Yes
ii. Same class of securities?
1. No
iii. At or about the same time?
1. Yes
iv. Same consideration?
1. Yes
v. Same purpose?
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vi.
vii.
viii.
ix.
1. Yes
d. You never want to rely on the five-factor test.
4. The Five-Factor integration test comes from the § 3(a)(11)
intrastate exemption – originally to determine whether a sale was
part of an intrastate offering.
a. It made its way from there to Rule 502 to apply to the other
Rules exemptions.
Mergers
1. In a stock-for-stock merger, the shareholder of the absorbed
company must agree to have their shares converted to the shares of
the new company.
a. The SEC used to deem this to be a non-sale (due to the lack
of shareholder choice).
i. However, the shareholders do get a vote for the
merger, so there’s some volition involved.
ii. Also, practically speaking, you can’t carve out a
merger from the definition of a sale: The
shareholders are clearly giving value (their old
shares) in exchange for securities.
iii. This leap of logic has extended to other areas
through Rule 145(a). (Such as reclassification).
2. R. 145(b) relieves the gun-jumping restrictions for covered
transactions because the shareholders will need disclosures.
a. Most of the drawbacks from R. 145(c)–(d) are now
relegated to shell company situations.
Stock Issued in Court
1. What if there’s a settlement in which an issuer agrees to settle state
fraud claims with extra stock for every share the πs own?
a. Not exempt! This is because § 3(a)(10) says that there must
be an expressly required fairness hearing in state court. No
such requirement exists for federal court (presumably it’s
more fair there).
2. There’s no § 3(a)(10) exemption for bankruptcy court because §
3(a)(7) already covers securities issued in bankruptcy court.
Can securities in a § 3(a)(10) exempt transaction be resold?
1. Same rule as before—your new security has the same restrictions
or lack thereof as the old.
Integration danger!
1. What if you have a public offering right after a private offering?
a. The SEC’s current position is that at some point, the private
offering activities must cease. 30 days after that, you must
file a registration statement.
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i. Do this, and there’ll be no problem with integration.
It’s a bright-line rule.
ii. This rule doesn’t work unless you have an exempt
private offering under R. 506
c. Spin-Offs
i. SEC v. Datronics
1. The scheme to avoid registration is that a private company merges
with Datronics’ subsidiary.
2.
3. The stock holders of the private company get Datronics’
subsidary’s stock in exchange for the private company’s stock.
a. On average, the private company gets 67% of the
subsidiary’s stock. Datronics gets 33%.
b. The private company has given away 1/3 of their company
just to avoid the registration process. That’s how
burdensome registration is.
4. Datronics argues that the above deal isn’t a sale for § 5 purposes.
a. Stock dividends aren’t normally considered sales because
they’re not “for value.”
5. The court says it’s enough that Datronics received value – it
doesn’t matter that the shareholders didn’t give value.
a. This is a questionable reading of § 2(a)(3). But, they got the
result they wanted.
6. Datronics doesn’t get a § 4(a)(1) exemption because they’re found
to be a co-issuer and an underwriter.
ii. How about legitimate spin-offs?
1. You don’t have to register a spin-off if it meets five conditions:
a. No consideration
b. Pro-rata distribution
c. Adequate information to shareholders and the market*
d. Valid business purpose
e. Securities are restricted (non-resaleable)
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2. *If you register as a reporting company under the Securities
Exchange Act, then this factor is met.
E. § 4(a)(1): Exemptions for transactions not involving issuers, underwriters, and dealers
1. § 4(a)(1) says the registration requirements only apply to issuers, underwriters, and
broker-dealers.
2. Who is an underwriter?
a. SEC v. Chinese Consolidated Benevolent Association
i. If an underwriter is involved, then there’s no § 4(a)(1) exemption.
ii. § 2(a)(11) covers a firm commitment underwriter because it says they buy
from an underwriter with intent to distribute.
1. Best efforts underwriters also are covered by § 2(a)(11) because
anyone who sells an issuer’s securities with intent to distribute
counts as an underwriter.
iii. In this case, a Chinese charity sells bonds for the Chinese government
without registration.
iv. The Chinese government is also in violation of § 5 because they’re an
issuer. No exemption applies to them.
1. Don’t miss that charges could’ve been brought against the Chinese
government.
v. The Benevolent Assocation could also have been charged with aiding and
abetting.
vi. Benevolent Association argues they’re not selling “for the issuer.”
1. They had no privity of contract and weren’t under issuer’s control.
vii. Holding: The court says it doesn’t matter—if the issuer gets some benefit,
then it’s “for an issuer.”
viii. Could a purchaser bring an action for rescission against the Benevolent
Association? Yes. Underwriters are subject to § 11 rescission actions for
violation of § 5.
b. SEC v. Guild Films Co.
i. Banks sold Guild Films stock that they possessed as collateral for loans
made to Roach, who had defaulted.
1. Roach got Guild Films stock in exchange for film rights.
2.
ii. SEC says the bank is an underwriter because it (1) purchased, (2) from an
issuer, (3) with a view to distribute, (4) to the public.
1. (1) The pledge of the stock is a sale because they give value and
it’s for an interest in the stock.
2. (2) The stock never “came to rest” because Roach sold so quickly
(see also § 3(a)(11) intrastate resale analysis). Therefore, the SEC
and the court considers the bank to have bought from Guild Films
itself (i.e., the issuer).
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a. If Roach had held onto the stock for 30 years, it would have
come to rest and the banks wouldn’t have been considered
to have bought from an issuer.
3. (3) The banks knew the overwhelming likelihood was that Roach
would default and they’d sell the stock.
4. (4) The stock was sold on an exchange, so it was going to be
distributed to the general public.
iii. This case doesn’t really hurt banks too much because element (3) is
usually not met—banks can almost always say that they didn’t expect to
have to resell stock held as collateral and, therefore, they’re not
underwriters.
c. Control Persons: Shareholders that could cause a company to issue a registration
statement are considered “control persons” and they’re issuers for the purpose of
determining whether someone who buys from them is an underwriter.
i. In the Matter of Ira Haupt & Co.
1. Park & Tilford (92% shareholders) sold to Schulte Interests, who
then sold to Ira Haupt, who then sold through his brokers to the
general public through the New York Stock Exchange.
2. Issue: Does Ira Haupt have a § 4(a)(1) exemption, or is he an
underwriter/issuer/dealer?
3. Schulte is in control of P&T, therefore he’s an “issuer” for the
purposes of § 2(a)(11).
a. For the purpose of defining whether or not the broker is an
underwriter (and for no other purpose), Schulte is an issuer.
4. Why doesn’t the § 4(a)(4) broker’s transaction exemption apply?
a. Because it’s only available to brokers acting only as
brokers. If you lose § 4(a)(1) exemption, you also lose §
4(a)(4) exemption.
5. The issue is whether selling a small enough number of shares will
constitute a distribution. The SEC seems willing to go along with
this idea, but it doesn’t work in this case because in the aggregate
it’s too large a distribution.
ii. United States v. Wolfson
1. Continental (40%) Wolfson Group (633,000 shares) Six
Brokers Public (NYSE)
2. Wolfson was “the guiding spirit” of the issuer.
3. Control is defined in Rule 405. It’s a functionl definition –
whoever has power to direct the management and policies of an
entity.
4. Wolfson doesn’t get a § 4(a)(1) exemption because he’s a control
person, making the brokers underwriters.
a. Holding: If the transaction involves an underwriter, there’s
no 4(a)(1) exemption.
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5. Note: A private person selling stock on the NYSE gets a § 4(a)(1)
exemption even though it involves a dealer.
a. This is contradictory, but we go along with it.
6. Are the brokers underwriters?
a. (1) They sold for (2) an issuer (Wolfson, the control
person), (3) with a mind to distribute, (4) to the public. So,
yes.
7. § 4(a)(4) exempts brokers who weren’t aware of their part in a plan
to distribute.
a. The court found that the brokers didn’t know about the plan
to distribute, so they are exempt under 4(a)(4).
b. There’s a line of authority that says a distribution is
quantitatively based. Therefore, 100,000 may not qualify as
a distribution.
c. The brokers didn’t know about the other 500,000 shares
sold.
iii. Where control persons are involved, watch out for the problem of turning
your broker into an underwriter and, thus, wrecking the 4(a)(1) exemption
for the whole transaction.
1. Why have this rule that makes it impossible for control persons to
sell significant numbers of securities?
2. The control person has the power to have the securities registered.
If they want to sell their stock, they should just have the entity
register the stock.
iv. § 4(a)(1½)
1. If a control person wants to sell stock tomorrow, what can she do?
a. Do a private offering.
i. It’s exempt because it’s not a distribution.
Therefore, there’s no underwriter and no issuer.
ii. This is a “4(a)(1½)” Exemption.
b. Avoiding the middle man will result in not being an issuer.
i. The problem arises when you use a broker who
becomes an underwriter thanks to your control
person status.
ii. As long as you don’t use a broker, 4(a)(1)
exemption will remain intact.
c. So, do a private sale (no distribution, so no underwriter) or
sell without a broker (also no underwriter).
3. Rule 144
a. Only applies to “restricted securities.”
i. Basically, these are securities purchased at a private offering via
Regulation D.
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b. As a regular person, you can sell restricted securities after 6 months as long as the
reports required by the Exchange Act were filed on time.
i. If the reports weren’t filed on time, then you must wait 12 months.
c. If R. 144 applies, then you definitely won’t be deemed an underwriter.
d. If you’re a control person, how do you use R. 144?
i. The same holding period applies as above.
ii. There must also be adequate public information available.
iii. It must be information required by 15c2-11.
iv. Control persons also have a restriction on the number of shares sold. The
limit is the greater of either 1% of shares outstanding or the average
weekly trading volume for any 3-month period.
1. This is the quantitative view of what qualifies as a distribution.
v. Finally, there’s a “manner of sale” restriction.
1. You must either deal with a “market maker” or do the sale in a
broker transaction.
e. If all of the above is followed, then your broker won’t be deemed an underwriter.
f. SEC has been much more generous with ordinary people than with control
persons.
i. Ordinary folk can unload all their stock in one go – no limitation on the
amount of securities sold.
g. R. 144A is a way to sell stock to big institutional investors.
h. Reg. S is the way to make offshore sales.
IV.
Regulation of Trading in Securities
A. Introduction to the Securities Exchange Act
1. Before the Digital Age, the securities markets were divided between auction markets
(NYSE) and dealer markets (NASDAQ).
2. Today, computers have overtaken the NYSE.
3. NBBO: “National Best Bid/Buy Offer”
a. The NBBO is the best (lowest) available ask price and the best (highest) available
bid price to average investors when they buy and sell securities.
b. The SEC’s rule allows this to be displayed for any given stock.
c. Regulation NMS requires that brokers must guarantee customers this price.
4. Who has to register with the SEC under the Exchange Act?
a. Registered Companies: (Companies with more than $10 million in assets, 2,000
accredited investors or 500 non-accredited investors).
5. What do such companies have to do?
a. File quarterly (10-Q) and annual (10-K) reports.
b. The short-swing profit rules apply to their insiders. No transactions within 6
months of each other.
c. Proxy rules apply (annual reports must be sent with any proxy solicitation).
d. The Williams Act applies (anyone buying 5% or more of the company has
disclosure requirements).
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6. Note: If you’ve previously sold stock pursuant to a registration statement, you’re subject
to the reporting requirements, but not to the Williams Act, proxy rules, or short-swing
profit restrictions.
B. Regulation of the Securities Markets
1. Order-Handling Rules:
a. When you place an order with a broker, the broker is required to buy at the best
available price.
b. NASDAQ has always provided the “inside spread” to investors, which is the best
buy/bid prices available from a dealer.
c. Today, though, the best prices available from non-dealers are also displayed.
d. The above rule is controversial because there are reasons why someone like an
institutional investor would select something other than the best price if there are
other advantages like speed or anonymity.
i. The SEC made the rule with retail investors in mind—they care only about
price.
ii. As a corollary, the SEC got the NYSE to change its antiquated trading
system to an electronic system more palatable to institutional investors.
iii. The remaining loophole in the market regulations is brokers can get
kickbacks from exchanges to execute a customer’s order through their
exchange.
1. Brokers lose their incentive to get “inside the inside spread” when
they’re getting a kickback.
2. Decimalization
a. The lowest denomination used to be 1/8 of a dollar, harkening back to Spanish
“pieces of 8” for some reason.
b. The denomination now can go as low as $0.01, but no lower.
i. Why no lower? To prevent front running by brokers. Otherwise, they’d
just put in an offer that’s $0.0001 higher than their client’s.
ii. They can still place an offer $0.01 higher, but I guess it costs slightly more
so it’s kind of a deterrent.
3. The Conundrum of High-Frequency Traders
a. How do high-frequency traders (HFTs) get ahead of everyone?
i. They put their computers right next to the exchange servers, giving them a
milliseconds-long time advantage in finding out when large transactions
are taking place.
1. They use this to do auto-trades and make a lot of money.
ii. They use algorithms to determine when institutional investors are making
big trades (which may be broken up into various smaller transactions) and
trading themselves accordingly based on the effect on the price.
iii. HFTs also do “pings,” which are small offers that will determine whether
or not an institutional investor is making a move. This is perfectly legal.
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iv. They also “spoof,” which is in a gray area of legality. Spoofing involves
placing a big sell order to see if anyone is buying. They then cancel the
order if it’s accepted, having gotten the information they wanted.
1. This could be a 10b-5 violation, but no one knows for sure.
“Spoofing” by its nature is an offer that the offeror doesn’t intend
to go through with. This may be illegal market manipulation or it
might not.
4. Electronic Communications Networks (ECNs)
a. This is a system that lets people find out the best buy or sell offers.
b. It’s a matching system – it matches buyers with sellers.
c. Institutional investors like ECNs because they’re fast and provide anonymity.
i. Others tend to swoop in and mess up the price when they know an
institutional investor is making a move.
d. The SEC does not like ECNs because they’re not transparent.
i. However, they tolerate them because institutional investors like them.
e. Dark Pools are a kind of ECN.
i. The difference is that the size and price of orders are not revealed to other
market participants.
f. The order handling rules make non-dark pool ECNs essentially a part of
NASDAQ.
5. The SEC sits astride the world of securities trading like the Titan of Braavos. Most
securities law is made by the SEC, not the courts or Congress.
a. There are also self-regulatory organizations: the stock exchanges (over which the
SEC has plenary authority) and FINRA (ditto).
b. Brokers and dealers must be apart of a registered association of brokers and
dealers. There’s only one such association: FINRA (formerly the NASD).
i. NASD merged with the NYSE and is now FINRA (brokers didn’t like
being regulated by two separate organizations).
6. What is an exchange?
a. Board of Trade of the City of Chicago v. SEC
i. This case harkens to a day when the ECNs couldn’t have registered as an
exchange, which angered the Board of Trade and the Chicago Mercantile
Exchange, which believed this was an unfair advantage for the ECNs.
ii. The 7th Circuit said a stock exchange can’t register as a broker-dealer—
only as an exchange.
1. So, the question is whether the ECN is an exchange.
iii. It matters whether Delta (the ECN in question) is an exchange because
they’ll be subject to a lot of extra rules if it is.
iv. Delta is a matching service which matches buy and sell orders.
v. Definition of “stock exchange” per § 3(a)(1) of the Exchange Act:
1. Any organization that maintains or provides a market place or
facilities for bringing together buyers and sellers or otherwise
performs functions commonly associated with a stock exchange.
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vi. Why isn’t Delta an exchange under that definition?
1. The “otherwise” is what could combine the two halves of the
definition with “generally understood,” therefore it’s at least
ambiguous whether or not Delta must be providing a marketplace
for bringing buyers and sellers together in a manner “generally
undertsood” to be a stock exchange.
vii. It’s not a big deal that Delta doesn’t have to register because the brokerdealers already have to register, and the SEC has plenary authority over
them.
viii. The Exchange Act mandates a governance structure of exchanges based
on a concept of them as member-owned rather than proprietary (ownerowned), so regulating proprietary ECNs as exchanges is not a good fit.
7. Antitrust Laws and Securities Laws: Which applies?
a. Silver v. NYSE
i. A broker was denied permission to establish a direct-wire phone
connection with brokers in the NYSE.
1. The NYSE refused to grant a hearing or explain why the
connections were denied.
ii. The general rule is that self-regulating exchanges are immune to antitrust
rules.
iii. However, the court found that the NYSE had violated antitrust rules under
the Sherman Act.
1. The antitrust rules—rather than securities law—applied in this case
because the SEC didn’t review the procedures through which the
broker was denied access for Due Process violations.
b. Credit Suisse Sec. v. Billing
i. The πs sued because of underwriters’ policy of “laddering,” which inflated
the IPO price.
1. Laddering is the practice of requiring buyers to commit to purchase
shares later at a higher price so as to increase the market price.
ii. “Tying” (requiring the buyer to also participate in a difficult offering) and
high commissions were also complained of as antitrust violations.
iii. All of the above is prohibited by the SEC.
iv. It matters whether antitrust or securities laws apply because antitrust suits
allow for treble damages and there aren’t private rights of action under
some SEC rules.
v. The underwriters probably will defend themselves by saying they weren’t
exactly laddering,but just asking what their intentions are.
1. The ones who’ll buy more shares at a higher rate later will be
invited to the IPO. So, it’s not necessarily an impermissible
express condition to buy.
vi. Holding: Securities law applies. The court says the SEC is in the best
position to decide whetherthey were laddering and tying.
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1. There’s nothing wrong with favoritism. What’s illegal is for
underwriters to get together and make requirements to buy later or
also buy difficult offerings to get in on the IPO.
2. The antitrust laws would step on the SEC’s ability to make policy
and draw fine lines such as the ones above described.
vii. There are four requirements for the SEC to displace antitrust law in a
given matter:
1. SEC has power to regulate;
2. SEC exercises that authority actively;
3. It’s a core SEC function;
4. Securities law and antitrust law are in conflict.
c. Gordon v. NYSE
i. Πs complained of the stock exchange’s fixed commission rates for brokers
– this was an antitrust violation.
ii. In the antitrust world, there’s never a justification for fixed commissions.
iii. Congress gave the SEC authority tofix commissions only if:
1. They’re reasonable; and
2. They don’t impose a burden on competition that isn’t necessary for
furthering the purpose of the Exchange Act.
iv. The SEC dropped fixed rates because the idea that customers couldn’t be
trusted to shop for a broker in their price range was very paternalistic.
1. The market would decide.
v. Price fixing almost never works. The cartel members will always cheat
each other. It onlyworksif there’s honor amongst thieves, which there
typically isn’t.
1. In the securities context, there would be side deals for free that
would effectively reduce the commission rate.
8. Compensation of Market Makers / Over the Counter Markets
a. Lehl v. SEC
i. The mark-up formula is: (change in price) / (original price)
ii. The mark-up charged by the broker in this case was 30%.
iii. Why is there a problem with charging high commissions?
1. NASD requires that brokers “observe high standards of
commercial honor and just and equitable principles of trade.”
a. Among other things, this requires commissions to be
reasonable.
iv. The SEC has a 5% rule of thumb regarding mark-ups.
1. Lehl argues the SEChas violated the APA by failing to go through
notice-and-comment rulemaking.
v. The court says this argument doesn’t fly because the SEC’s 5% rule is
guidance referring to precedent from adjudication.
1. The SEC says the 5% rule wasn’t meant to be a hard-and-fast rule,
so it shouldn’t be a formal rule.
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vi. The 30% mark-up is obviously too high, so there’s no problem with
deciding Lehl runs afoul of the NASD guidelines.
9. Market Data
a. Why do stock exchanges sell data?
i. They have “depth of book” data, which is information on limit orders.
ii. It’s an indication of the depth of the market (i.e., the liquidity of the
market).
iii. Volume information is also worthwhile—it lets people predict price
changes.
b. The SEC doesn’t want to regulate the sale of market data, though brokers want
the exchanges’ sale of market data to be regulated.
C. Regulation of Broker-Dealers
1. Fiduciary Duties of Broker-Dealers
a. Dealers have adverse interests from buyers/sellers, therefore they don’t have
fiduciary duties.
b. Brokers:
i. Brokers have fiduciary duties when the account is discretionary—the
broker is making investment decisions as your agent.
ii. There is gray area where a non-discrretionary accounthas a broker who
noSelf-Regulation
1. The most important self-regulatory organization is FINRA.
a. The SEC has ultimate authority, but they allow FINRA
autonomy for the most part.
2. Why have so many layers of governing authority?
a. FINRA doesn’t have to abide by the 4th and 5th
Amendments, so they have power over its members that the
SEC does not.
i. As a result, FINRA can enforce vague, allencompasing rules like “just and equitable
principles of trade.”
b. FINRA can also regulate the day-to-day activities of
brokers and dealers. They have localized authority.
3. The courts are the last resort for appealing FINRA actions.
4. FINRA doesn’t create private rights of action, whereas the SEC’s
rules can create a private cause of action.
5. The Securities Act makes anyone who deals securities a “dealer,”
who must be a member of FINRA.
6. The Exchange Act makes a distinction between a “dealer” and a
“broker.”
a. A broker is an agent (sells for clients – profits come from
commission), while a dealer is a principal (sells on his own
account – profits come from the spread between the buy
and sell price).
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b. Both have to be in the business of selling securities.
iii. netheless offers advice on investments, etc.
iv. The current majority rule is that a non-discretionary broker doesn’t owe a
fiduciary duty, even if the broker makes recommendations.
v. Courts are slowly evolving such that some will say that a nondiscretionary broker has fiduciary duties if he has dominion over the
account.
c. Remember: There’s always a state law option somewhere if the federal securities
laws don’t reach far enough.
2. Quasi-Fiduciary Duties and Shingle Theory
a. History:
i. Boiler rooms involved selling worthless stock to people by phone.
1. The brokers didn’t know anything about the stock beyond the
promotional materials.
ii. To crack down on boiler rooms, the SEC adopted “shingle theory.”
b. Shingle Theory: If someone hangs out their shingle as a broker, then there’s an
implicit representation that they have done research, etc., re: the stocks they’re
selling.
i. 10b-5 violations require fraud. Fraud requires a lie. Shingle Theory
supplies the “lie” element of the 10b-5 violation.
c. However, theoretically, it’s not really a lie if they don’t have fiduciary duties.
i. Santa Fe v. Green: The federal securities laws are not meant to regulate
the substantive fairness of conduct – that’s a state law issue.
d. Shingle Theory sounds a lot like punishing misconduct rather than fraud, which
contradicts Santa Fe. However, the courts have not officially done away with
Shingle Theory.
3. Manipulation
a. Manipulation is doing something that causes others to trade based on your actions
such that the prices will change in a way that’s beneficial to the manipulator.
i. “Pump and dump” is an example. Buying and selling repeatedly to give
the appearance of volume.
ii. Manipulation is extremely hard to prove because of the mens rea
requirement – it has to be purposeful manipulation.
b. SCOTUS says the manipulation rules are within the SEC’s purview becaues
manipulation conveys a message which is a lie.
i. Therefore, the manipulation envisioned in § 9 is similar to the fraud
envisioned in § 10.
4. Short Selling
a. Short Selling is when you sell borrowed stock with the intention of returning the
borrowed shares after the price has decreased.
i. It’s a bet that the stock price will go down.
b. The SEC once regarded short selling in a down market as illegal manipulation.
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5.
6.
7.
8.
i. The “tick rule” prohibited selling short at a price that’s lower than the last
price or at the same price as the last price, but lower than the last different
price.
1. E.g.:
a. $7
b. $5
c. $5
d. $5
e. Can’t sell at $5 now since it’s lower than the last different
price.
ii. This rule mitigated downward pressure on the market caused by short
selling.
c. The SEC did away with the “tick rule” because decimalization made the rule
meaningless – you could just sell for a penny higher than the last lowest price.
i. More important, though, was that the tick rule was a rejection of the
efficient market hypothesis. The SEC “got religion” and did away with the
tick rule in the late 2000s.
d. The SEC still looks askance at short selling – there are rules that require
exchanges to ban short sales on stocks that have gone down 10% in a day (the
“ciruit breaker rule”).
Naked Short Selling
a. Selling short without actually borrowing the stock for delivery.
i. The standard for when naked short selling is OK is if the broker
“reasonably believes he’ll be able to borrow the stock in time to deliver it
by the delivery date.” (Rule 203(b) of Reg. SHO).
b. Naked short selling is generally legitimate.
c. This is problem for bookkeeping. A lot of people think naked hsort selling should
be illegal, but the SEC hasn’t taken any actions to make this happen.
d. Short selling in an offering is only allowed if you cover with stock from the
secondary market (Rule 101).
Regulation M
a. Reg. M deals with what you can buy in a public offering.
b. The “restricted period” in which you can’t buy what you’re selling varies in
length depending on a company’s size (see supra Part II.D).
Stablilization
a. Stabilization is when you place a limit order at the offering price so as to keep the
price stable.
i. This isn’t a fraud because everything is disclosed.
b. Allowing stabilization allows people to sell more stock because of status quo bias.
c. Laddering is illegal, but there’s nothing wrong with inquiring about a buyer’s
intention to make sure they’re buying more later.
d. Ditto with rewarding good customers with hot issues (i.e., “tying”).
Net Capital Rules
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a. Brokers are required to have sufficient liquidity to prevent a disorderly
dissolution.
b. SIPC is the FDIC for brokers – if your broker goes bankrupt, then you’ll get at
least some money back.
9. Margin Rules
a. The Federal Reserve Board has rules such that the broker can only finance 50% of
a customer’s purchase of stock.
b. Why? They don’t regulate how much you can borrow for other things.
i. Partly because of policy favoring home ownership.
ii. Mostly because some think that the Great Depression was caused by
highly leveraged stock investing.
1. No one cares if this is true.
iii. Exception: A broker can lend 100% of a stock purchase price on a shortterm bridge basis.
iv. Margin calls are never required unless you make new purchases.
1. I.e., you don’t need to provide fresh cash to get back to 50% equity
unless you want to buy new stock.
10. Arbitration
a. Any time you sign an agreement with a broker-dealer, you agree to arbitrate any
disputes.
i. Every broker requires this.
ii. The arbitrations are esssentially home games for the broker industry
(arbiters come from the industry).
b. Why does the SEC permit such a favorable deal for brokers?
i. Good question. FINRA requires, though, that you get the choice to have a
panel composed of non-broker industry folks.
11. Duty of Best Execution
a. The broker must use “reasonable diligence” to determine whether the broker is
OK selling or buying at the NBBO price rather than searching through alternative
markets.
b. Reasonable diligence factors:
i. The character of the market for the security (e.g., price, volatility, relative
liquidity, pressure on available communications)
ii. Size and type of the transaction
iii. Number of markets checked
iv. Accessibility of the quotation
v. Terms and conditions of the order as communicated to the broker
c. The Duty of Best Execution never requires a broker to get “inside the spread.”
12. Duty to Protect Limit Orders
a. No front running is allowed. A broker can’t sell or buy for its own account before
executing a customer’s order.
b. Also, if your client puts in a limit order, you can’t sell at that price even if you’re
making a market.
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i. If you want to make a market, then the best bet is to reject limit orders.
c. The SEC says there’s a duty to protect limit orders – even if the limit price is only
available to market makers.
13. Fraud and the Duty to Investigate
a. Elements of Common Law Fraud / 10b-5
i. Lie
1. A lie is either: An affirmative misrepresentation, a half-truth,
omission when there’s a duty to disclose.
ii. Material
1. What a reasonable person would have wanted to know
iii. Mens Rea (scienter for 10b-5)
1. Scienter: You knew you were lying or were reckless in not caring.
iv. Reliance
1. π acted based on the lie.
v. Loss Causation
vi. Damages
b. Hanly v. SEC
i. Brokers recommended stock in Sonics even though it was a terrible
investment with numerous red flags.
1. The company’s invention might be pretty good, but they can’t get
anyone to finance it. So, they never turned a profit and went
bankrupt.
2. Therefore, the company wasn’t intrinsically worthless, but still a
highly dubious investment.
ii. The SEC revoked the brokers’ licenses—banning them from selling stock
for life.
iii. Opinions (like a stock recommendation) can be lies (and thus the basis of
fraud) if you don’t really believe them or if you have no basis for them.
iv. The SEC said the brokers should have informed investors of the
company’s problems.
v. If the broker is a fiduciary, then they have a duty to disclose material facts.
vi. The court finds that Shingle Theory applies here—there’s an implicit
representation that the brokers have investigated. They didn’t, so that’s a
lie.
1. Ragazzo’s not so sure about this.
2. Scienter is also a problem if there’s no lie because failure to
investigate is more like negligence, not recklessness or knowledge
(i.e., scienter).
c. O’Connor v. R.F. Lafferty
i. Π invested her $200,000 divorce settlement with a broker.
ii. She wanted safe, secure investments but also a 10% return per year.
1. This is a tall order.
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iii. Π says brokers had committed fraud in conduct by choosing unsuitable
investments.
iv. Rules:
1. NASD Rule: Broker must have reasonable grounds to believe the
investment is suitable for the customer.
2. NYSE rule: The “Know Your Customer” Rule.
3. FINRA (current rule): Leans to suitability, but you must also know
your customer.
v. The court finds π can’t prove Δ had intent to defraud or recklessness.
1. The court is influenced by the fact that π should have known the
stocks were unsuitable.
a. She got full disclosure in the monthly statements.
d. Nesbit v. McNeil
i. This case is all about churning.
1. Churning is where the broker makes more trades than is suitable
for the client so as to drive up commissions.
ii. Π was unsophisticated. She depended on the broker, so he had control.
iii. How to know if there’s churning? The turnover ratio. A ratio of 6 is
thought to be churning.
iv. Π wanted stability, income, and growth – another tall order (utterly
contradictory goals).
v. Broker apologized for the bad stock choices – bad idea because it
seemingly admitted to churning.
vi. Outcome:
1. Total commissions earned by broker: $250,000.
2. Jury found that $134,000 of the commissions were excess due to
churning.
3. Her portfolio did increase in value by $182,915.
vii. The court says that profits don’t offset damages for excess commission –
otherwise the broker could just keep buying and selling the same stock
over and over, collecting excess commissions without adding value.
viii. The court also says that trading losses are available as damages in a
churning case.
1. This is questionable, says Ragazzo. The losses don’t have anything
to do with churning per se.
ix. Rule: Gains don’t offset losses from excess commissions. However, losses
in trading can be awarded as damages.
14. Penny Stock Reform Act of 1990
a. Why special regulations for penny stocks?
i. The market is much thinner.
ii. It’s dominated by a small number of players.
iii. There is a lack of information because the stocks are seldom traded
(therefore analysts don’t pay a great deal of attention).
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b. Under the penny stock reform, brokers can’t make a market for penny stocks
unless the information from 15c2-11 is made available.
i. This is a backdoor way of requiring disclosure.
15. Investment Advisers Act
a. Lawyers are subject to the IAA when investment advice is not incidental to their
law practice but, rather, a separate business activity.
i. E.g., If a sports agent is always giving investment advice, then it’s not
incidental. She must register under the IAA.
b. Registering under the IAA means you have fiduciary duties to your client.
c. Financial Planning Association v. SEC
i. The FPA wants broker-dealers to be subject to the IAA because they think
their exemption gives them an unfair advantage.
ii. Congress, in the IAA, said a broker-dealer who (1) doesn’t get special
compensation and (2) gives investment advice that’s only incidental to
broker-dealer services is exempt.
1. The SEC thinks section (F), which allows the SEC to exempt
“other persons,” means that the SEC can exempt anyone they want,
including broker-dealers who were not previously exempted.
iii. Holding: The court disagrees. “Other persons” means types of people not
previously listed in (A) through (E).
1. Applying Chevron, the court decides that the statute is
unambiguous and, therefore, they don’t defer to the SEC’s
interpretation.
2. The SEC doesn’t have the power to exempt broker-dealers who
don’t meet (C)’s requirement per this case.
iv. Dodd-Frank empowers the SEC to raise the obligations of brokers.
V.
Civil Liability
A. Introduction
1. Class Actions
a. Pros:
i. Allows aggregation of claims that’d be too small on their own.
ii. Keeps corporations honest – they can’t get away with causing small
amounts of harm to vast numbers of people.
b. Cons:
i. They let lawyers and defendant corporations screw over the plaintiffs by
settling on terms that don’t really address the harm.
ii. It puts enormous pressure on Δs to settle with extortionate strike suits.
c. The PSLRA (Private Securities Litigation Reform Act) of 1995 was strongly anticlass action.
i. Silicon Valley was a big lobby for the PSLRA.
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ii. There’s almost always something fraudulent going on, so lawyers would
sue whether or not they knew something fraudulent was going on at the
outset of the suit.
d. PSLRA makes it a felony to pay someone to be lead plaintiff.
i. The lead π is presumptively the individual with the largest economic
damages.
ii. The lead π chooses the counsel and makes the fee arrangement.
iii. This reform means the attorneys are no longer driving the class action
process.
e. There’s also an automatic stay of discovery while the court decides the 12(b)(6)
motion. If the case fails under 12(b)(6), then the court is required to decide
whether the attorney should be sanctioned under Rule 11.
i. This prevents a “fishing expedition” before the plaintiff has a specific
claim.
2. Arbitration (again)
a. The Securities Act doesn’t allow people to waive their rights created by the Act in
a securities contract.
i. Therefore, no waiving the right to bring a 10b-5 action.
b. Wilko had held arbitration clauses to be unenforceable.
c. Now, under McMahon/Rodriguez, the arbitration clause isn’t thought to be a
waiver of rights under either the ’33 or ’34 Acts.
d. Dodd-Frank authorizes the SEC toban or limit the use of arbitration clauses in
broker contracts.
3. ’33 Act Liability
a. There are a wide variety of anti-fraud rules.
i. § 9 prohibits manipulation
ii. § 10b prohibits fraud in connection with a pruchase or sale.
iii. § 11 deals with fraud in a registration statement
iv. § 12 deals with offering and selling without registration and fraud in
prospectuses and oral communications.
v. § 17 prohibits fraud in connection with an offer or sale.
b. Remember that all of the anti-fraud provisions are different. In some sense, you’re
always thinking of all of them at the same time – analyze each when you’re
looking to sue someone.
4. Inquiry Steps:
a. (1) Who has standing to be in the π class?
i. Must have purchased stock that was sold in the offering.
ii. Can be bought in the secondary market if they can be traced back to the
shares issued in the offering.
b. (2) Δs can be:
i. Issuers
ii. Underwriters
iii. Directors
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iv. Anyone who signed the registration statement
v. Any expert who certified information
c. (3) A prima facie § 11 action must show a lie and materiality.
i. When the lie is a half-truth or omission,the materiality question and the lie
question are the same.
ii. For misrepresentations, however, lie and materiality are distinct questions
– don’t mix and match.
iii. The issuer has no due diligence defense, but the other categories of Δ can
raise a defense that they were not negligent.
iv. Π must prove reliance in the prima facie case when the issuer has put out
an earnings statement covering a year, beginning after the date of the
registration statement.
1. The non-reliance defense is available to all Δs- it’s when the Δ can
prove that the π knew the truth.
v. §11(e): Any portion of the decrease in the stock’s value that’s not caused
by fraud can be deducted from damages (Δ has burden).
B. § 11 Liability
1. The due diligence defense is the most important inquiry – it turns the mens rea
requirement into a negligence standard.
a. Non-Experts must show they did reasonable investigation and, at the end of the
investigation, reasonably believe the registration statement is true.
i. For expertised portions, the non-expert must have no reasonable ground to
doubt the truth of the expert opinion.
b. Experts must do a reasonable investigation and reasonably believe the truth of the
experts’ own resulting expert opinion.
c. In pari delicto is another defense.
2. Escott v. Bar Chris Construction Corp.
a. It was a shock to a number of people when this case extended § 11 liability to the
people actually specified in § 11.
b. The frauds in this case involved sales that were not really sales.
c. First step of seller financing is getting the purchaser to sign a promissory note.
Why?
i. Because the note is negotiable (i.e., it has value as a transferrable
instrument).
d. Bar Chris sold the notes to a factor, which pays a discounted price for it.
i. Now the purchaser pays the factor rather than the seller.
ii. This was the Δ’s standard method of financing.
e. Alternative financing schemes:
i. Scheme 1: Δ sold the bowling alleyto Talcott, whothen leased it to the
customers. This is essentially the same situation as the standard method.
ii. Scheme 2: Δ sold to a subsidiary, which would lease to customers.
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1. Under this scheme, Bar Chris is on the hook for 100% of the
factor’s payments.
f. Frauds:
i. The registration statement was fraudulent as to Alt. Scheme 2 by saying it
was a complete sale, which it was not.
ii. They counted as sold things that weren’t sold.
iii. They also lied about their backlog by saying that contracts were sold
which were in backlog.
g. The directors who participated in the fraud aren’t discussed in the case because
they have no due diligence defense.
h. For the ones who didn’t actually participate in the fraud, the question is whether
they can have the § 11 due diligence defense.
i. Kirchner, the CFO and Treasurer:
1. Kirchner knew the lanes weren’t really sold and that Bar Chris was
on the hook for 100% of contingent liabilities. Therefore, he is f’d.
ii. Birnbaum (lawyer, in-house counsel, and director)
1. He came on board right as the statement was about to be
submitted. Is he supposed to hold up the registration so he can do
due diligence?
a. Yes! Either do the due diligence or resign. There’s no
exception for new directors.
2. The court says Birnbaum should have done the due diligence
expected of a lawyer. (The standard for due diligence is based on
the relative expertise of the person).
a. What is expected of a lawyer? Review the contracts! If he
ahd, he’d see that contracts were missing or gave Bar Chris
much higher liability than had been reported.
b. He also should have read the board minutes.
3. The court is mindful that different people have different abilities.
A lawyer is expected to do the due diligence that a lawyer would
do.
iii. Auslander (outside director, chairman of a bank)
1. Court says he’s liable for the non-expertised portions of the
registration statement.
2. He asked the directors if everything was in shape, then believed
their answers without further investigation.
a. He should have verified what the other directors said. If he
had done anything – looked at the books, read contracts,
etc. – then the court would have given him the due
diligence defense.
i. You can’t passively take others’ word for it and get
the due diligence defense.
iv. Grant (lawyer)
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1. He didn’t read the contracts or board minutes. He also drafted
much of the registration statement, making his situation worse.
v. Drexel (underwriter)
1. The underwriters should have looked at the contracts to see if the
sales and financing arrangements were as described by
management.
a. Passive acceptance of the management’s representations
isn’t enough.
2. The other underwriters argue it’s the lead underwriter’s job to do
due diligence, but this doesn’t fly because the lead underwriter’s
diligence was found wanting.
a. What if the lead underwriter gets the due diligence defense,
but the other underwriters did nothing?
i. Unclear! Most assume that the other underwriters
are cloaked in a successful due diligence defense on
the part of the lead underwriter.
vi. Peat, Marwick (auditors)
1. How much an auditor investigates depends on what they’ve been
finding.
a. If you’re finding red flags, then you do a more thorough
investigation.
b. Peat, Marwick didn’t do an adequate investigation, says the
court, because even a cursory investigation would have
revealed red flags which would have spurred further
investigation.
i. This is the leading case for how the § 11 due diligence defense works.
3. In re WorldCom, Inc. Securities Litigation (2004)
a. WorldCom’s fraud involved capitalizing expenses. This meant pushing expenses
into the future rather than having it all reducing net income in the year the
expenses occurred.
i. WorldCom did this on a massive scale. They’re bankrupt and the auditor
is bankrupt, so the πs sue the underwriters.
b. Only stuff that’s subject to the audit opinion is expertised.
i. The auditor sends a “cold comfort letter” as to the whole registration
statement, but this doesn’t make the whole thing expertised.
c. Issue: Is Rule 176 a safe harbor for experts and underwriters?
d. The underwriters argue that Rule 176 relieves them of liability because it imposes
a duty of due diligence that’s “reasonable under the circumstances.”
e. Holding: The court says, “No way!” R. 176 doesn’t reduce the standard of due
diligence.
i. It doesn’t relieve liability when there’s a shelf registration and not enough
time to do a full investigation.
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ii. The underwriters should have caught the red flag of the E/R ratio being
way lower than competitors’. Competitors had more expense because they
didn’t have a fraudulent capitalization scheme.
iii. Also, the underwriters didn’t reasonably believe the registration statement
because they were internally sheltering themselves from WorldCom’s
securities.
f. What does R. 176 do?
i. Shelf registration doesn’t mean the standard of due diligence is lessened.
ii. If you have worked with the company a lot in the past, you don’t
necessarily need to do a full, duplicative investigation every time thanks to
R. 176.
4. § 11 Causation and Damages
a. Causation isn’t part of the πs’ prima facie case. But, Δ can reduce liability by
disproving causation (§ 11(e)).
b. Damages
i. If you have not yet sold the stock, it’s the lower of what you paid or the
IPO price minus the stock value at the time of the suit.
ii. If you sold the stock before the suit began, then the formula is the price
paid or the IPO price (whichever’s lower) minus the resale price.
iii. If the stock goes up after you bring the suit, then the Δ benefits if you
haven’t sold yet. It’s best to lock in the low price by selling if you’re
planning on bringing suit.
c. Akerman v. Oryx Communications, Inc.
i. Πs’ damages in this case would be $4.75 (the IPO price) minus $3.50
(price at the date of suit) = $1.25 per share.
ii. Πs assert that Oryx lied on their pro forma because they made a mistake
that overstated earnings for the month of March. The earnings actually
occurred in April.
iii. Potential Materiality Argument
1. Stock price actually went up after disclosure – this is a way of
saying that reasonable investors don’t care.
2. The district judge just assumes the lie was material, but Ragazzo
thinks materiality is the better argument for Δ because π, not Δ,
must prove that element.
iv. The district court found that the Δ overwhelmingly met its burden in
showing no causation; it granted summary judgment.
v. Πs argued that insider trading made the price go down before the public
disclosure.
1. They should have argued that the information leaked out from
insiders to the market at large, causing the pre-public disclosure
price to drop. The problem is this would be very hard to prove.
vi. The court also rejected both parties’ statistical analyses because they don’t
compare Δ with similarly sized companies in the same industry.
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1. A good analysis would have controlled for different risk levels, etc,
so that similar companies are treated similarly.
1. Standing in § 11 Suits
a. Hertzberg v. Dignity Partners, Inc.
i. Any person who acquired the security in question has standing to bring a §
11 action.
ii. Δ argues that after-market purchasers can’t sue on § 11.
1. This is a losing argument because § 11(g) says that the lesser of the
IPO price or the purchase price is the basis for damages.
a. If after-market purchasers can’t sue, then there’d be no
need to calculate damages based on anything but IPO price.
b. The tracing language would also be pointless since there’s
no tracing issue when the stock was bought at the IPO.
iii. There’s no tracing issue in this case because there was only one offering –
all stock on the market is tainted by the bad prospectus issued for that one
offering.
2. What Counts as a Lie under § 11?
a. Omnicare, Inc. v. Laborers District Council Pension
i. Issue: When can opinions be lies sufficient to support a fraud action?
ii. Omnicare is in trouble for giving rebates in exchange for pharmacies
pushing their drugs.
iii. In the prospectus, the officers stated “we believe the rebates were not
illegal.”
1. Πs argue this was a lie.
iv. Opinions and Lies:
1. An opinion can be a misrepresentaiton when the speaker doesn’t
actually believe the opinion. This is almost impossible to prove,
though.
2. An opinion can also be a misrepresentation when there is a fact
embedded in it.
a. E.g.: The statement is, “I believe our cars can withstand a
crash because of our special XYZ technology.” No such
technology exists, so the statement contains a lie.
3. An opinion can also be a half-truth.
a. In this case, the court says that it could be a half-truth
because a statement of opinion in a prospectus implies that
it’s backed up by reasonable investigation.
b. This is pretty easy to allege, so it’s opened the door to a lot
of securities litigation.
v. Holding: A “we believe…” statement must be backed up by reasonable
investigation.
1. This looks like it adds mens rea to the plaintiff’s prima facie case.
The π must show a lie, materiality, and now a lack of due diligence
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(i.e., negligence) when there’s an opinion that turns out to be
wrong.
C. § 12 Liability
1. Actual rescission is the strict liability remedy for a § 12 violation – the Δ must repay the
entire purchase price of the security, plus interest, minus any income received from the
security. Other kinds of benefits, like dividends, don’t need to be reduced from the
rescission payment.
2. A § 12 prima facie case must include a lie and materiality.
a. There’s a “reasonable care” defense for Δs. It’s an open question how this
standard relates to the § 11 due diligence standard.
i. There’s no affirmative duty to investigate in the “reasonable care”
defense.
ii. Must prove, though, that you could not have known that the prospectus
was misleading.
iii. So, § 12 “reasonable care” could be either more generous or harsher than
the § 11 “due diligence” defense.
iv. The answer depends on the court. It might depend on who you are
(sophisticated or not, e.g.).
v. Remember that the “reasonable care” defense essentially makes a
negligence standard of the mens rea element.
b. To defeat the reliance element, Δ must show that πs knew about the mistake
already.
c. Loss causation: § 12(b) allows Δs to reduce their liability to the extent they can
disprove loss causation.
i. Texas’s version of § 12 doesn’t require any loss causation to get
rescission. Therefore, Texas is more generous to πs in almost any case.
3. Who can you sue under § 12?
a. The statute says “anyone who offers or sells a security.”
b. Pinter v. Dahl
i. Πs sue for rescission because the Δs encouraged them to buy oil and gas
interests that had not been registered with the SEC.
ii. The interests in question were securities because § 2 defines undivided oil
and gas interests as securities.
iii. The Reg. D safe harbors don’t apply because:
1. No disclosure
2. Unsophisticated investors
3. Not registered in a state
iv. The private offering exemption also doesn’t work because the investors
weren’t all sophisticated.
v. Holding: Anyone with a financial interest in the sale is a seller.
vi. Dahl is a seller because he solicited the other investors so as to strengthen
his own investment.
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1. How to prove this? Gauge how much the investment required the
solicited investors’ money.
vii. How can § 12 give rescission as a remedy against solicitors?
1. Court says a possible reading of the statute is that a seller could be
someone who solicitied the sale, not just the person who passes
title to the buyer.
2. For policy reasons, the court says that for a solicitor to be a seller,
the solicitation must have been for the solicitor’s financial gain.
viii. In pari delicto is another defense in § 12 actions: If the π is at least equally
at fault, then the π can’t recover against the Δ.
ix. Privity does matter if there’s been a claim of sellers. You can only sue
your direect seller. However, an issuer is always a seller in a firm
commitment underwriting.
4. § 12(a)(2): Fraud in the prospectus
a. 12(a)(2) makes any person liable who offers or sells a security by means of a
prospectus or oral communication that includes a material misrepresentation or
material omission.
b. Π is not required to prove reliance, only that he or she did not know of the
material misrepresentation or omission.
c. Pricipal issue is: What is a prospectus, exactly?
d. Gustafson v. Alloyd Company, Inc.
i. The Wind Point shareholders are the πs. They bought their stock in a
purchase agreement, not in a public offering.
ii. Issue: Was the stock sales contract a prospectus?
iii. Despite the broad language of § 2(a)(10) (which calls any written
communication which offers a security for sale is a prospectus), the court
applies statutory interpretation canons to determine that a private sales
contract is not a prospectus.
1. They say it wasn’t Congress’s intent to allow § 12 liability for nonpublic stock offerings, so they determine that “communication”
means a public communication.
2. Allowing liability for private transactions isn’t the point of the ’33
Act, which is all about regulating public offerings.
iv. The court goes to § 10, which lists information that has to be in a
prospectus in a registration statement, to get at what a prospectus is. The
court is saying that the prospecut sis a document to accompany
registration statements.
1. However! A Free Writing Prospectus isn’t part of a registration,
yet must also contain information required by § 10.
2. The Securities Act has a sharp division between public and private
prospectuses. This makes the court’s logic shakey.
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v. § 12(a)(2) also cuts against the court’s interpretation because the
exemption of governments from 12(a)(2) liability implies that a nonregistration written document is a prospectus.
vi. Holding: It’s clear now that there’s no 12(a)(2) liability for non-public
offerings.
1. However, it can be a difficult question as to what is a public
offering. It’s unclear exactly where 12(a)(2) is effective now.
D. § 17 Liability
1. § 17 punishes fraud in connection with the offer or sale of a security (same elements as
10b-5).
2. Differences between § 17 and 10b-5:
a. § 17 applies to offerees, not just actual purchasers and sellers (as is the case for
10b-5).
b. 10b-5 is broader in other respects. § 17 only applies to offerees (and buyers) while
10b-5 applies to both buyers and sellers.
c. 10b-5 has a higher mens rea requirement (recklessness)
i. 17(a)(1) requires recklessness while 17(a)(2) and 17(a)(3) do not.
d. There is no private right of action under § 17, which is a bummer for plaintiffs.
The DOJ and SEC alone enforce it.
E. Liability under §10b and 10b-5
1. Rule 10b-5 Overview
a. There’s definitely a private right of action under 10b-5.
i. The courts have come to find that whether a private right of action exists is
a matter of congressional intent. Congress must explicitly grant a private
right of action.
ii. § 10b doesn’t explicitly say there’s a private right of action, but Congress
has never complained about it, so the private enforcement is grandfathered
in.
b. Advantages of 10b-5:
i. You don’t always have to prove reliance (there is a presumption of
reliance in “fraud on the market” cases).
ii. Remedy is the difference between what you got and what you would have
goten were it not for the deception.
1. This is better than rescission (the remedy in the other private
causes of action) if the value of the stock has increased.
iii. If the fraud is not in a registration statement or prospectus, 10b-5 is your
only cause of action (§ 17 has no private cause of action)—it’s allinclusive.
c. Disadvantages of 10b-5:
i. You have to prove scienter (unlike common law fraud)
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ii. You can’t get punitive damages or attorney’s fees as with common law
fraud.
d. 10b-5 is the catch-all anti-fraud provision.
i. It applies to any security.
ii. You can still bring a 10b-5 action if you also have a claim under § 11 or §
12.
2. 10b-5 is meant to punish fraud, not unfairness (a state law issue)
a. Santa Fe Industries, Inc. v. Green
i. The πs are complaining about the merger of Santa Fe and Kirby Lumber.
1. Only Santa Fe’s board has to vote on it.
ii. The merger price is $150 per share. The fairness opinion from Morgan
Stanley puts the value at $125 per share.
1. However! The assets are worth $640 per share.
2. Why???? $125 is the going concern value. So, selling is a nobrainer since the assets are worth so much more than the business.
iii. The board can’t be forced to sell because of the Business Judgment Rule.
iv. Asking for an appraisal won’t work, either, because the πs would only get
$125 per share – the value as a going concern.
v. Πs argue 10b-5 applies becaue the going concern price is a manipulation
and, therefore, fraud.
vi. The court says “no,” manipulation has a specific meaning in the securities
context. It’s when you know something that the market doesn’t.
1. § 10b says that the SEC may regulate “deceptive” or
“manipulative” actions, so there must be some element of deceit
for there to be a 10b-5 claim.
2. Manipulation must be the equivalent of a lie.
a. No manipulation here because everything is disclosed.
Therefore, no lie.
vii. Holding: To be actionable under the securities laws, there must be
deception involved.
viii. The court is also philosophically oppoesd to the πs’ argument.
1. The securities laws aren’t involved in regulating fairness.
2. Securities laws are about:
a. Disclosure
b. Preventing fraud
c. Regulating markets
3. Fairness is a matter for state law.
ix. Shingle Theory is the crypto-exception. It’s really about fairness. This
case cuts against Shingle Theory, though it hasn’t been explicitly rejected
by the courts.
3. Lower courts have avoided applying Santa Fe v. Green.
a. Goldberg v. Maridor said if there’s any failure to make disclosures, then 10b-5 is
a viable claim.
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i. This has cut a large hole in Santa Fe v. Green.
4. 10b-5 Contributory Negligence Defense
a. Δs used to be able to defend against 10b-5 by arguing the π failed to do due
diligence.
b. However, this was a bit unfair because it allows the Δ to succeed by proving π
was negligent while π can only succeed by proving Δ was reckless.
c. Some courts now say that πs must be equally or more culpable for the Δ to have a
successful contributory mens rea defense.
5. Duty to Update and Duty to Correct
a. Duty to Correct:
i. This arises when you say something that you thought was true at the time,
but turned out not to be true at the time that you said it.
ii. The Duty to Correct always involves a statement that was wrong at the
time it was made.
b. Duty to Update:
i. This arises when the statement was true at the time it was made, but
subsequent events have rendered the statement misleading (i.e., a halftruth).
c. In re Time Warner Inc. Securities Litigation
i. Unnamed sources within Time made statements in the press about
potential deals that turned out not to be successful. Time was also looking
at alternative means of satisfying their debts, but did not disclose them.
1. Time’s talks with “strategic partners” to allay $10 billion in debt
were referenced in an official statement. To wit, “We hope the
talks are successful.”
ii. Citing the unnamed sources in the π’s prima facie case doesn’t fly because
facts must be pleaded with particularity.
1. Scienter (and state of mind generally) is an exception—it doesn’t
need to be pleaded with particularity.
iii. The standard for making a prima facie case in a fraud case are stricter
because even being accused of fraud is damaging.
1. Therefore, fraud must be pleaded with particularity.
a. This means you must plead who, what, when, where, and
how.
2. You can’t bring a 10b-5 case based on third party statements
unless the company adopts them.
a. There’s no obligation to correct rumors, etc., that aren’t put
out by the company itself.
b. The π must cite the misstatement, who made it, when, etc.
iv. Everybody believes there’s a Duty to Correct, but there’s an even split
with regard to the Duty to Update.
v. Pros and Cons of Duty to Update
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1. Argument for a Duty to Update (2nd Cir.): If the statement “lives
on” and becomes misleading, there’s a duty to update or else
become liable for a half-truth.
2. Argument against a Duty to Update (7th Cir.):
a. The statement should only be viewed in its original context.
An 80% forecast 3 months ago isn’t an 80% forecast today.
b. Also, a duty to update would be onerous on companies –
they’d have to constantly be updating.
3. Ragazzo says it’s a close call. It’s questionable whether anyone is
being misled.
vi. Here, the court says Time didn’t have a Duty to Update.
1. They did, however, have a duty to disclose the alternate
approaches considered by the company.
a. These alternate plans make the “we are pursuing strategic
partners” statement a half-truth because it leaves out the
other plans Time was considering.
vii. Dilution of control isn’t at issue here since it’s a huge company and no one
will have a controlling stake.
viii. Economic dilution is at issue, though.
1. Offering stock shouldn’t dilute the stock price. As long as the new
shares are sold at a fair price, there should be no economic
dilution.
2. Here, however, Time sold stock at a lower price, which caused
economic dilution.
a. If this was the plan all along, then the “strategic partners”
statement was an actionable half-truth.
6. Materiality in 10b-5 Actions
a. Basic Incorporated v. Levinson
i. Basic, in 1977, said no merger talks were under way. This was an
affirmative lie.
ii. The other lie was when Basic said they didn’t know what caused heavy
trading in their stock.
iii. In reality, the merger talks were probably leaking out to the public in dribs
and drabs.
1. Basic had to suspect this. Therefore, Basic saying they don’t know
what’s causing the heavy trading is a half-truth.
iv. Basic argues that the “agreement-in-principle” rule should apply, meaning
that preliminary merger negotiations are per se immaterial.
1. Rationales:
a. The rule facilitates value-creating mergers by allowing
secrecy.
i. The court says, “F that – that’s repugnant to the
securities laws’ policy concern of full disclosure.”
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b. It’s a bright-line rule, easy to administer.
i. “F that, too,” says the court.
c. Investors can’t be trusted with the information – they might
overvalue it.
i. “F that, also. Investors shouldn’t be treated like
children.”
v. Holding: There’s no “agreement-in-principle” exception to materiality.
Preliminary negotations are not per se immaterial. It depends on facts and
circumstances.
vi. Holding 2: There is a magnitude/probability balance to decide what
investors would want to know (and, therefore, what’s material) about
future events.
1. The court doesn’t address whether earnings forecasts and
projections are subject to the same rule.
2. Note: “No comment” isn’t a vlid way to avoid disclosing material
information. It’s a half-truth in almost all circumstances.
b. Matrixx Initiatives, Inc. v. Siracusano
i. Issue: Does an issuer have a duty to disclose statistically insignificant
information?
ii. Πs sued under 10b-5, alleging that Mattrix made misleading statements
(half-truths) that did not disclose the potential liability for a defect with
one of their products.
iii. Facts:
1. Scientists have told Matrixx that some individuals have lost their
sense of smell after using their drug.
2. It’s not a stastically significant number of people – can’t draw
correlations from it.
3. It’s still possibly material becaues the FDA and medical
professionals don’t require statistically relevant info to draw
causation.
a. Therefore, a reasonable juror could think it’s material and
that a reasonable investor would want to know.
4.
iv. Is there scienter?
1. Matrixx hired a panel and commissioned studies on the issue, so
they clearly thought it was important to them. Therefore, they were
at least reckless in not caring that the omission was material.
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7. Forward-Looking Statements and “Bespeaks Caution” Doctrine
a. “Bespeaks Caution” Doctrine is a safe harbor that prevents fraud liability for
forward-looking statements if they’re accompanied by meaningful cautionary
statements.
b. It’s unclear which elemnt of fraud Bespeaks Caution addresses.
i. It’s thought to be Materiality, but Lie and Reliance are also affected.
c. The PSLRA adds safe harbors for companies that don’t have actual knowledge of
the falsity of the statement.
d. Pro: This rule encourages full disclosure of things that wouldn’t otherwise have to
be disclosed in order to get the safe harbor.
e. Con: It removes teeth from the securities regulations.
f. In re Worlds of Wonder Securities Litigation
i. Facts:
1. WOW’s biggest problem is they couldn’t raise sufficient money to
keep up with their orders.
2. WOW had a junk bond offering to raise funds, but it wasn’t
enough and the company folded.
ii. Investors sued and challenged four forward-looking statements:
1. Statement 1: Prediction of liquidity.
a. Court says the cautionary language is sufficient – they
disclosed they’ve always had problems with cash.
2. Statement 2: Internal Controls
a. Again, Δ disclosed that they have had problems in the past
with their internal controls. Plus, they never said the
problem was solved.
3. Statement 3: Revenue Recognition / Sales Practices
a. The court said the effect of stock balancing, guaranteed
sales, etc. had too speculative an effect.
i. That doesn’t mean it’s not material, though.
b. Also, it’s standard practice for toy companies to have stock
balancing and generous return policies, so the court said
there’s no need to specifically disclose them. The investors
should have known already.
i. Ragazzo isn’t so sure about this.
4. Statement 4: Sales figures.
a. Πs said Δ should’ve disclosed the magnitude of the decline
in sales.
b. Court says investors should have known sales would
decline more than last quarter’s sales decline.
i. Again, Ragazzo says this is questionable – there’s a
big difference between a 20% drop and a 40% drop.
iii. Takeaway: This is a very powerful defensive doctrine and courts will
construe it liberally.
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g. Harris v. Ivax Corp – Or, “What is a forward-looking statement?”
i. Πs complain that Δ didn’t disclose the possibility that good will would
have to be written-down.
ii. Issues:
1. Was “reorders are expected to improve” a forward-looking
statement?
a. Yes, says the court.
2. How about, “The challenges are in the past”?
a. Yes, too, because only time will tell if the challenges are in
the past.
b. However, there’s an argument that this is an assessment of
the current situation.
c. The court, however, says that this statement is forwardlooking in substance. It’s the same as, “As we move
forward, these won’t be a problem.”
3. There is also a mixed list of future predictions and factual
statements.
a. The mixed list of future predictions and factual present
statements get protection as a unit because it’s in the
context of a future prediction.
iii. Takeaway: The courts are trying hard to apply the Bespeaks Caution
doctrine to a broad variety of statements.
8. Reasons, Opinions, Beliefs, and 10b-5
a. Virginia Bankshares, Inc. v. Sandberg
i. Δ solicited proxies for a merger so that the burden of proof in the entire
fairness test would shift to the π if the minority voted to approve the
merger.
1. In the solicitation, they said the price being offered for the buy-out
was at a substantial premium.
2. Πs sued because the price turned out to be $18 less than what an
internal study said the stock was worth.
ii. The court finds that the issue here is really one of fairness, which is a state
fiduciary duty issue.
1. When an opinion stated by amangement wasn’t really held by the
speaker, it’s a state law issue.
2. Policy: Securities laws shouldn’t be involved with the kind of fact
question at play in whether someone really believed something.
iii. This case is more than likely overruled by Omnicare, where the SCOTUS
said that stating a belief that isn’t really the speaker’s belief is a lie for §
11 purposes (it probably counts for 10b-5, too).
iv. As controlling shareholders, the VBI shareholders had a duty to disclose to
the minority shareholders.
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v. Basic suggests that the study (despite problems with it cited by VBI) is
material – investors would want to know.
vi. Saying the price was at a premium to book value and market value is a
half-truth.
1. The market is thin and dominated by the majority shareholders.
2. The assets that make up the book value are listed at their purchase
price. They have appreciated substantially.
9. The “In Connection With” Requirement
a. § 10b gives the SEC authority to enforce rules prohibiting fraud “in connection
with” the purchase or sale of securities.
b. Semerenko v. Cendant Corp. (3rd Cir. 2000)
i. Cendant made a tender offer to ABI.
1. Tender offers are at 150% of the current stock price.
a. Prices don’t quite rise 50% because the deal might fall
through.
b. They rise because of the premium potential.
2. In this case, the offer fell through.
3. Investors who bought ABI because of the potential for a tender
offer sued Cendant (the offeror) for fraud.
a. The failure of the tender offer caused the investors to lose a
lot of money.
4. The lie was about Cendant itself, not the tender offer – the
investors claimed that Cendant misrepresented its financial health,
thus fooling people into thinking it could afford to acquire ABI.
5. The court says there are two elements for a misstatement to be “in
connection with” sale of a security:
a. Materiality, and
b. The means of dissemination are such that an investor would
presumably rely on it in making the purchase.
c. SEC v. Zanford
i. The broker in this case is in trouble for taking the proceeds from mutual
fund sales for his customers and depositing them into his own account
rather than his clients’.
ii. SEC sues based on 10b-5. The issue is whether the fraud was “in
connection with the purchase or sale of a security.”
iii. The court says it satisfies the “in connection with” requirement because
trading securities is part of the fraudulent scheme.
1. He steals after he trades.
2. Ragazzo says this is basically embezzlement, which isn’t a 10b-5
concern.
iv. The O’Hagan decision is relevant. In that case, the court found that 10b-5
covers insider trading because there’s securities trading and a breach of
duty even though the two aren’t directly connected.
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1. O’Hagan decision requires this result in Zanford.
v. Is there a private 10b-5 claim for the purchasers of the securities?
1. No, because no fraud has been committed as to the purchasers.
10. Culpability
a. Ernst & Ernst v. Hochfelder (US 1976)
i. First Securities president was committing fraud by getting customers to
send him personal checks under a fraudulent investment scheme.
ii. The issue: FS and the president are both bankrupt (and the president also
committed suicide), so the plaintiffs sue the auditor for negligence.
1. FS’s auditor, Ernst & Ernst, is the Δ. Π claims they were negligent
in failing to catch the fraud.
a. If they had, they’d have found out about the “mail rule”
(nobody was allowed to touch the president’s mail), which
is a huge red flag.
iii. Primary and Secondary Liability
1. There’s no private “aiding and abetting” cause of action in the 10b5 context, so there’s got to be a primary violation on the Δ’s part.
a. For private litigation – SEC can still sue for aiding and
abetting.
2. The courts have tussled with this, ending up with a rule where
you’re primarily liable for statements for which you’re essentially
the author.
a. So, an accountant is primarily liable for a fraudulent
accounting letter.
b. Otherwise, only the issuer is primarily liable.
3. It’s hard to say there’s aiding and abetting here for two reasons:
a. No scienter
b. No underlying securities fraud – the president’s fraud isn’t
in connection with a securities transaction.
iv. The court finds that scienter, not mere negligence is necessary for a 10b-5
violation.
1. The § 10b language says the SEC may promulgate rules against
“manipulation or deceptive” conduct.
a. These words indicate scienter.
b. 10b-5’s language indicates strict liability, but it can’t
exceed the instructions of § 10b, so the court reads a
scienter requirement into the rule.
v. § 18 is useless for the πs because the mens rea is actual knowledge and π
must prove actual reliance.
vi. § 9 is also not as good because it requires intent to manipulate prices.
vii. Trade-Off Theory
1. Another reasoning for requiring an elevated mens rea is the fact
that 10b-5 has a private right of action.
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2. The court decides that ’33 Act causes of action have more
procedural restrictions and, therefore, the mens rea is negligence
while the ’34 Act has fewer procedural limitations and, thus, has a
higher mens rea requirement.
a. Statutes of limitations are more restrictive for ’33 Act
claims.
viii. The social benefit of the negligence rule would be more deterrant and,
therefore, better auditing. The cost is more frivolous law suits.
ix. The lower courts are nearly unanimous that scienter means “reckless or
knowing,” but the SCOTUS hasn’t ruled on this.
1. No one has exactly defined “recklessness.”
a. Is it an objective or subjective standard? A higher form of
negligence (objective) or a lower form of intent
(subjective)?
x. For a forward-looking statement, the PSLRA makes it so the mens rea is
“actual knowledge.”
xi. If the SEC sues for an injunction, should there be a scienter requirement?
1. Yes, because § 10b binds the SEC and § 10b covers only
“deceptive or manipulative devices.”
b. § 17(a) would be a popular statute for private plaintiffs because two out of three
subsections only require negligence. However, courts have found there’s no
private cause of action under § 17.
11. Reliance and Causation in 10b-5
a. Basic Incorporated v. Levinson (Fraud-on-the-Market Theory)
i. In an omission case, there’s no reliance requirement because it’d be too
hard to prove.
1. Reliance is presumed from materiality.
ii. Fraud-on-the-Market Theory also allows for a presumption of reliance.
1. FOTM involves untrue statements or omissions which filter into an
efficient market, which alters the stock price.
iii. If you had to prove actual reliance, it’d be impossible to bring suits on
behalf of regular investors in a class action because regular investors
wouldn’t have heard the fraudulent statement and their reliance would be
highly individualized and it’d be impossible to establish a common
question.
iv. Either the court is being disingenuous in its belief in the efficient market
hypothesis, or it has accepted that markets don’t have to be 100%
efficient, but merely mostly efficient, to make the FOTM theory viable for
establishing the reliance element.
v. Three ways of rebutting FOTM presumption of reliance.
1. Rebut an individual π’s reliance (“You would have bought the
stock anyway, ya turkey!”)
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2. Disprove price impact (Δ proves the fraud had no impact on the
price)
3. Show the market was not efficient
vi. If you can show there’s no price impact, then there’s no loss causation in
addition to no FOTM reliance presumption.
vii. How to show whether a market was efficient or not?
1. Number of analyst reports
2. Daily trading volume
3. S-3 eligibility of the issuer.
b. Semerenko v. Cendant Group
i. Cendant was accused of lying about its own financials in the context of a
tender offer for ABI stock.
1. ABI stockholders sued based on Cendant’s false financial
statements.
ii. Issue: Can πs establish reliance when Δs put out statements to correct the
old, wrong statements.
iii. Holding: You can only rely on the most recent disclosures for he purposes
of a 10b-5 action.
iv. Beyond the reliance issue, there’s a bigger problem for the πs: Scienter.
1. Did Cendant really know there was a problem, or were they merely
negligent?
v. Reasonable reliance is also problematic as a fairness issue.
1. Why is it fair that if the Δ had scienter and the π merely was
negligent, π can’t recover.
2. Some circuits allow π to recover if his fault is less than Δ’s.
3. Others won’t allow π to recover if the π was reckless.
4. In any case, mere negligence or “unreasonableness” shouldn’t
defeat a π’s claim, and it won’t in most courts.
vi. **Remember: The 10b-5 “in connection with” requirement is satisfied for
anyone who purchased or sold stock based on Δ’s lie (doesn’t matter if it’s
not Δ’s stock – see Semerenko, where it was the acquiring company who
lied).
12. Loss Causation
a. Dura Pharmaceuticals, Inc. v. Michael Broudo
i. Dura falsely claimed that it expected the FFDA would approve its product.
ii. Loss causation is an issue here.
1. You can’t get the full difference between the purchase price and
current price unless you’ve actually lost money on the sale.
2. If you sell before the fraudulent information comes out, you can’t
recover, either, because the lie wouldn’t have had an effect yet.
iii. To have loss causation, you must buy while there’s an inflated price, then
sell after there’s been disclosure which deflates the price.
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b.
c.
d.
e.
iv. It’s typical in this kind of case for πs to bring in experts to do regression
analysis to show the price decline was caused by the disclosure of the lie.
v. Why can’t the π show loss causation in Dura?
1. The price actually wasn’t impacted by the disclosures. The market
already had incorporated the truth despite the lie.
2. Merely because people lied isn’t enough; there must be loss
causation.
Hypo: What if you buy $100 bonds with the intent just to collect the $100 at their
maturation, but it turns out they’re riskier, so the price you paid should have been
lower?
i. If the issuer still pays everything they’re required to pay, there’s no loss
causation (unless you sold the bonds at a loss).
Loss causation requires a fairly strict connection between what you were lied to
about and the cause of your loss.
i. E.g., no loss causation if a shipwright lies about a ship’s top speed, and it
later sinks because of a big storm.
Erica P. John Fund, Inc. v. Halliburton Co.
i. Issue: Do you need to show loss causation or price impact for class
certification?
ii. Holding: No, you do not. The fraud-on-the-market presumption of reliance
does not require a showing of price impact.
1. However, the Δ can still rebut the presumption of reliance by
proving a lack of price impact.
iii. You do have to plead and prove loss causation, however, to get any
damages.
1. This is problematic for class certification because loss causation is
an individualized issue. However, the court couldn’t hold that loss
causation is a class certification issue because the appellate court
didn’t address it.
iv. Don’t mix-and-match elements of a 10b-5 claim!
Blue Chip Stamps v. Manor Drug Stores
i. To remedy an anti-trust issue, Blue Chip had to reorganize. They let
retailers buy stock in proportion to their share of the market.
ii. Some offerees sued under 10b-5, arguing that Blue Chip was overly
pessimistic about the offering.
1. Probably as a sneaky way of getting around the anti-trust
settlement and keeping retailers from getting into their stamp
program.
iii. Πs argue they would have bought stock but for the lie.
iv. Court: You must have actually purchased or sold to have a 10b-5 claim.
1. The court looks to § 17, which applies to offers of sale. However, §
17 has no private right of action.
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2. Congress knew how to give protections to offerees, but chose not
to in § 10b.
v. Every other express remedy for private rights of action require you to be a
purchaser or seller.
1. Therefore, why should implied private rights of action apply to
offerees?
vi. There are also policy reasons:
1. Vexatious litigation could ensure if πs could claim they would
have bought stock but for a lie.
2. Also, courts won’t make case-by-case exceptions, such as when
there is privity between the offeror and offeree (as was the case
here).
13. 10b-5 Summary
a. Remember that derivatives like warrants can be the subject of a 10b-5 action,
even if you choose not to buy the underlying stock. Derivatives are securities
according to § 2(a).
b. Breach of fiduciary duty claims aren’t 10b-5 claims unless there’s a purchase or
sale involved.
c. 10b-5 has a lot of affirmative requirements:
i. Must plead and prove scienter.
1. Difficult to plead under PSLRA.
a. 2nd Circuit: Must plead that Δ had opportunity and
motivation to lie.
b. To prove, must show that Δ knew or was reckless in not
caring.
2. Reliance is easier thanks to FOTM and the presumption of reliance
in the case of omissions.
3. Must plead and prove loss causation.
4. Damages are calculated based on the value of what you paid and
what you got.
a. Sometimes, if you can prove it, you can get the difference
between what you were promised and what you got.
b. Equitable relief is also available, but subject to equitable
requirements (most importantly, there must be no adequate
remedy at law)
d. The biggest advantage of 10b-5 over other private causes of action in the
securities laws is that you’re not limited to rescission as a remedy.
i. When you can get more than just your money back with your damages,
10b-5 is the way to go.
ii. There’s also a slightly longer SOL (2 years from when you discovered the
lie, but no more than 5 years in any case).
e. Standing:
i. You can sue primary violators or control persons of same:
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1.
2.
3.
4.
Issuer
Control persons (see § 20 of the ’33 Act)
Experts who attest falsely
Underwriters
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