Securities Regulation
Professor Bradford
Spring 2003
Exam Answer Outline
The following answer outlines are not intended to be model answers, nor are they
intended to include every issue students discussed. They merely attempt to identify the
major issues in each question and some of the problems or questions arising under each
issue. They should provide a pretty good idea of the kinds of things I was looking for. If
you have any questions about the exam or your performance on the exam, feel free to
contact me to talk about it.
I graded each question separately. Those grades appear on the front cover of your
blue books. To determine your overall average, each question was then weighted in
accordance with the time allocated to that question. The following distribution will give
you some idea how you did in comparison to the rest of the class:
Question 1: Range 2-9; Average 6.26
Question 2: Range 2-8; Average 5.33
Question 3: Range 0-8; Average 5.05
Question 4: Range 0-8; Average 5.52
Question 5: Range 2-8; Average 5.43
Total (of exam, not final grades): Range 2.66-7.34; Average 5.51
Question 1
Broker’s contact with Client occurred on March 30, after the March 1 effective
date. Absent a refusal order or stop order, the only part of section 5 that applies after the
effective date is section 5(b). Section 5(a) only applies “unless a registration statement is
in effect,” and one is. Section 5(c) only applies “unless a registration statement has been
filed,” and one has.
Section 5(b)(1) makes it unlawful for any person, using, among other possibilities,
the mails, to transmit a prospectus, unless it meets the requirements of section 10. Broker
used the mails, so the jurisdictional requirement is met. Nothing in section 5 limits its
coverage to offering participants, so Broker’s actions could be covered.
Section 2(a)(10) defines “prospectus as, among other things, a written
communication which offers any security for sale; it expressly includes letters within its
terms. An offer to sell is “every attempt or offer to dispose of, or solicitation of an offer
to buy, a security . . . , for value.” Section 2(a)(3). Broker is attempting to interest Client
in purchasing Seedling stock and that purchase would clearly be for value, so the letter
appears to be a prospectus within this broad definition. This letter does not fall within the
section 2(a)(10)(a) free-writing exception because it was not accompanied or preceded by
a section 10(a) final prospectus. And the letter does not fall within the section 2(a)(10)(b)
exception or its Rule 134 expansion because it includes more than either allows, and does
not include the mandatory language. This letter also does not meet the requirements of
section 10.
Gustafson limits the term “prospectus” to public offerings, but this is a registered
public offering, so that is not a concern. However, there is also language in Gustafson
equating prospectuses to carefully drafted documents of wide public dissemination. If
that dictum is followed, this personal letter would not qualify as a prospectus and there
would be no section 5(b)(1) violation.
Assuming the letter is a prospectus, Broker has violated section 5(b)(1) unless he
has an exemption. The section 4(1) exemption is not available because Broker, a
professional broker, is a dealer. Section 2(a)(12). The section 4(4) exemption is not
available because Broker is not merely executing Client’s purchase order. The letter is
soliciting the purchase and section 4(4) excludes “the solicitation of such orders.”
Section 4(3), as modified by Rule 174, is available, however. Section 4(3)
excludes transactions by a dealer, except for transactions within a specified time after the
effective date or the first offer, whichever is later. Ordinarily, for IPOs, the relevant time
period is 90 days, which would not help Broker. His letter was clearly sent within 90
days of the effective date. However, Rule 174 shortens that time period in certain cases.
Rule 174(d) reduces the time to “twenty-five calendar days after the offering
date” if “as of the offering date, the security is . . . authorized for inclusion in an
electronic inter-dealer quotation system sponsored and governed by the rules of a
registered securities association.” This is a reference to NASDAQ, and Seedling’s
common stock was authorized for trading on that system as of the offering date.
“Offering date”, for purposes of this rule, is the later of the effective date or the date of
the first bona fide offer to the public. Rule 174(d).
Broker’s letter was more than 25 calendar days after the effective date, so it is
exempted from section 5 by section 4(3) as modified by Rule 174(d). Broker did not
violate section 5.
Question 2
Coverage of Section 12(a)(2). Section 12(a)(2) imposes liability for misleading
statements made “by means of a prospectus or oral communication.” The allegedly
misleading statement here was oral—the statement in the elevator. A prospectus must be
written, or on radio or T.V. Section 2(a)(10). The Supreme Court in Gustafson indicated
that “oral communications” in section 12(a)(2) is limited to oral communications relating
to prospectuses—which the Court indicated is limited to public offerings. This is clearly
a registered public offering but, when the Court required oral communications to be
related to a prospectus, did it mean that the oral statement must be directly concerned
with the prospectus, or merely that it must be in a public offering. This statement is not
directly related to the contents of the prospectus, because the prospectus says nothing
about the Superior contract, but that’s probably not a requirement.
Materially Misleading. Finance’s statement clearly is misleading. He said he
was sure IHOP would get the Superior contract even though, at the time, Superior had
dropped IHOP from the bidding. A misstatement is material if there is a substantial
likelihood that a reasonable investor would consider it important. TSC Industries.
Without more details about the size of the company and the size of the contract, it is
impossible to know for sure if it’s material, but it probably is, since it’s a multi-milliondollar contract. However, it is not clear from the problem was else the market knew
about the bidding process for Superior’s contract. If the market knew that IHOP had
been dropped from the bidding, that should be reflected in the price IHOP is able to get
for its stock, and Finance would have a “truth-on-the-market” defense similar to that in
Wielgos.
Seller. To be liable, Finance must have offered or sold the security to Buyer.
Pinter v. Dahl was a section 12(a)(1) case, but the relevant language of section 12(a)(2) is
the same, and it is accepted that Pinter also applies to section 12(a)(2). Finance did not
directly sell any securities to Buyer, so he is not a seller in the title-passing sense.
Therefore, he is a seller under Pinter v. Dahl only if he solicited Buyer for value—to
serve his own or the issuer’s personal interest. Finance did not purposely solicit Buyer,
but his statement would be considered an offer under the broad reading of “offer to sell”
in section 2(a)(3)—it would affect Buyer’s willingness to purchase the IHOP stock. The
real question is whether the solicitation has to be intentional—did Finance “attempt” to
offer the stock to Buyer? If he did, he probably did so for value. As CFO of IHOP, he
was serving the financial interests of IHOP in his conversation with Pro.
Reasonable Care Defense. If he is a seller, Finance may still avoid liability by
showing that “he did not know, and in the exercise of reasonable care could not have
known, of such untruth or omission.” Finance did not know what he was saying was
untrue, although he certainly was reckless. Given his position, a single phone call would
have provided an answer. Although most courts don’t believe section 12(a)(2) creates a
duty of inquiry, but see Sanders v. John Nuveen, it’s hard to see how making statements
deliberately with no knowledge of whether or not they were true, when that knowledge is
easily obtainable by the speaker, could constitute reasonable care.
Buyer’s Knowledge. Buyer did not know of the untruth, so the defense in the
parenthetical in section 12(a)(2) does not apply, and a plaintiff clearly has no duty to
investigate under section 12(a)(2).
Damages. The ordinary measure of damages in a section 12 action is
rescission—Buyer can recover the full purchase price, since he still owns the security.
However, section 12(b) provides a negative causation defense. Finance is not responsible
for any part of the loss he can show did not result from the misleading statement.
Finance will try to argue that, since the price did not drop when the truth was announced,
the fraudulent statement had no effect. See Ackerman (dealing with a similar issue under
Section 11’s negative causation defense). However, IHOP’s announcement of a
government contract on the same day could have masked any negative effect. Moreover,
the news might have leaked out earlier, and explain part of the earlier drop (although the
fact that the market as a whole was also falling cuts against that argument). Buyer could
also argue that the lie never affected the market in the first place, since it was a private
conversation in an elevator. However, the representatives of several large institutional
investors were also in the elevator; if the lie was material, it is unlikely there was no
positive effect on the market. The key is whether the court will follow Ackerman in
deciding that the lack of a post-announcement price reaction shifts the burden to the
plaintiff. Whoever has the ultimate burden is likely to lose.
Question 3
Rule 506 is a safe harbor for the section 4(2) private offering exemption, and
therefore its policy rationale is the same as that for section 4(2). As the Supreme Court
indicated in Ralston Purina, the private offering exemption is limited to those who are
“able to fend for themselves” and therefore do not need the protection Securities Act
registration provides. To be able to fend for themselves, these investors need access to
the kind of information registration would provide and sufficient sophistication to
evaluate that information.
Rule 506 does not exactly fit that policy rationale. For one thing, its 35-purchaser
limit, Rule 506(b)(2)(i), seems a little odd in this context. The number of purchasers in
the offering seems irrelevant to their need for protection; Ralston Purina itself discounted
the importance of the number of investors.
As to non-accredited investors, the sophistication requirement in Rule
506(b)(2)(ii) seems appropriate to the policy rationale. The provision for a sophisticated
purchaser representative for an unsophisticated investor also fits the rationale,
particularly given the conflict-of-interest provisions in Rule 501(h). The representative’s
sophistication can protect the unsophisticated purchaser.
However, the Rule 506(b)(2)(ii) sophistication requirement does not apply to
accredited investors and it is here that the fit to the policy rationale breaks down a little.
Some of the accredited investors in Rule 501(a)—such as most broker-dealers, banks, and
investment companies—undoubtedly are sophisticated enough that they don’t need the
protection of registration. But that is probably not true for many of the people in other
categories. For example, is a natural person whose joint income with her spouse is
$300,000 [Rule 501(a)(6)] necessarily sophisticated with respect to investment matters?
And many people today who have assets with a value in excess of $1 million [Rule
501(a)(5)] aren’t that sophisticated, particularly when the value of retirement assets is
included. For that matter, does every corporation with $5 million in assets [Rule
501(a)(3)] really have investment sophistication? That is not a particularly large business
by today’s standards, particularly if the business is some type of manufacturing.
Moreover, Rule 506 does not perfectly fit the access to information aspect of
Ralston Purina. Rule 502(b)(1) requires that information be provided to non-accredited
investors, but it does not require that accredited investors be furnished the same
information. They have an opportunity to request information, Rule 502(b)(2)(v), but, as
discussed above, not all of the accredited investors will have sufficient sophistication to
ask for, or sufficient bargaining power to obtain, the information necessary to evaluate
the investment.
Finally, it’s not clear that the prohibition on general solicitation is necessary to
satisfy the policy rationale for Rule 506. If all the eventual purchasers are able to fend
for themselves, why should it matter how the issuer contacted those purchasers, or
whether the issuer also contacted other potential purchasers who aren’t sophisticated, as
long as the issuer doesn’t sell to the unsophisticated offerees?
Question 4
Nothing in section 5 of the Securities Act limits its application to sales by the
issuer, so Cash is required to register unless he has an exemption. The common
exemption for resales is section 4(1)—“transactions by any person other than an issuer,
underwriter, or dealer.”
Section 4(1)
The issuer, Exxam, is not involved in Cash’s resales. Fleecam is a professional
broker, which makes her a dealer. Section 2(a)(12). However, if that’s the only problem,
the section 4(3) exemption would exempt her since Cash’s shares are not part of an
underwriter’s unsold allotment and the required time period has expired since the Exxam
offering was 18 months ago. Thus, Cash has the section 4(1) exemption unless his
resales involve an underwriter.
Fleecam is not an underwriter, unless Carl is and it’s participating in his
underwriting. Fleecam is not selling for an issuer (or control person) in connection with a
distribution, since Carl is not a control person. However Carl himself might be an
“underwriter” as defined in section 2(a)(11) if he purchased from the issuer, Exxam, with
a view to distribution. It’s not clear if Carl’s 18-month holding period is sufficient to
establish investment intent. The case law under the statute saw two years as the turning
point; after that, investment intent was presumed. However, Rule 144 has now shortened
its holding period to one year, so perhaps the case law under section 4(1) would also be
adjusted. If this is long enough to establish investment intent, Carl is not an underwriter.
Carl can also establish investment intent by showing a change of circumstances
since his purchase of the Exxam shares. However, his impending retirement is something
he could have anticipated 18 months ago. Therefore, unless his retirement was
unexpected for some reason, he cannot show an adequate change of circumstances. In
any event, the SEC purported to abolish the “change of circumstances” test when it
adopted Rule 144, although it’s not clear it has the authority to do this, since this test is an
interpretation of the “purchased with a view” language in the statute.
If Carl can’t establish investment intent, and therefore the securities have not
come to rest from Exxam’s offering, Carl is an underwriter only if his resales constitute a
“distribution.” Before the issuer’s offering comes to rest, resales constitute a distribution
if the resales are inconsistent with the issuer’ original exemption. Carl’s resales would
clearly be inconsistent with Exxam’s Rule 505 exemption. Rule 505(b)(2)(ii) says the
securities may be sold to no more than 35 purchasers, although this excludes accredited
investors. Rule 501(e)(iv). Exxam sold to exactly 35 nonaccredited investors. If Carl
resells to 15 individuals, only half of whom are accredited, the securities will come to rest
in the hands of more than 35 nonaccredited purchasers, a violation of Rule 505(b)(2)(ii),
and therefore inconsistent with Exxam’s exemption. Carl would therefore be an
underwriter if he is unable to establish investment intent.
Rule 144A
The Rule 144A safe harbor would be unavailable to Carl because it limits sales to
qualified institutional buyers. Rule 144A(d)(1). These individuals are not institutions.
See Rule 144A(a)(1).
Rule 144
The Rule 144 safe harbor also would not work. These are restricted securities
under Rule 144(a)(3)(ii) because they are subject to the Regulation D resale limitations.
Therefore, Rule 144 would be available if all the conditions of the rule are met. Rule
144(b).
Carl has held the stock for the one-year period required by Rule 144(d), but not,
unfortunately, for the two-year period after which the conditions are relaxed for noncontrol persons. See Rule 144(k). Exxam appears to meet the current public information
requirement of Rule 144(c), since it is an Exchange Act reporting company and has filed
its reports on time. But Carl does not meet either Rule 144(e) or (f).
Rule 144(e) limits the amount of securities Carl can sell to the greater of 1% of
the shares of the class outstanding, Rule 144(e)(2), (1)(i) [1% of 1,000,000 is 10,000] or
the average weekly trading volume, Rule 144(e)(1)(ii),(iii) [20,000]. Carl cannot sell
more than 20,000 shares and he wants to sell 25,000.
In addition, Rule 144(f) says the shares must be sold in a broker’s transaction,
which precludes solicitation by the person selling the securities. Rule 144(f)(1). Rule
144(g)(2)(ii) relaxes this slightly, allowing Felicia to solicit customers who have
expressed an interest in the securities in the past ten business days, but it’s unlikely all 15
individuals fall within this. Thus, Rule 144(f) is also not met, so Rule 144 is unavailable
to Cash.
Question 5
There are two ways in which this ad might be misleading. First, the statement
that Linkcyst cards are “The Best in the World: No One Else Comes Close” is arguably
misleading because most experts believe there are technically superior Ethernet cards.
Second, stating that Linkcyst has 85% of the market while omitting the rumors about
Macrohard’s potential entry into the market could be misleading.
A fact is material if there is a substantial likelihood that a reasonable investor
would consider it important in deciding how to act. TSC Industries.
Best in the World Statement
The first statement appears to be mere puffery; most people would not expect this
to have much meaning. The appearance of this statement in an advertisement rather than
in a financial context reinforces this argument. Furthermore, Linkcyst may believe its
cards are the best in the world, no matter what most of the experts say. And, if only
“most” of the experts believe there are technically superior cards, at least some of them
must think Linkcyst’s cards are the best. Even the experts who believe other cards are
technically better may believe Linkncyst’s card is best when price is considered.
Moreover, the experts’ opinions are probably public, so there’s a truth on the market
defense. See Wielgos. If the market is already aware of the experts’ opinions, this
statement would not have any effect on the market price.
85% Market Share Statement
The second statement is more difficult. Omitting Macrohard’s planned entry
while claiming an 85% market share is arguably misleading, if the Macrohard rumors are
material.
Macrohard’s entry into the market is a future event that may or may not occur.
Therefore, the Basic probability and magnitude test must be applied. The probability that
the event will occur must be balanced with the magnitude of the effect on Linkcyst if it
does occur.
The magnitude here could be large, but that’s not totally clear. This product is
responsible for 1/3 of Linkcyst’s revenue and income, and the entry of a huge, cash-rich
company like Macrohard could have a big effect on both Linkcyst’s market share and its
profits. On the other hand, Macrohard has never made computer hardware and it’s not
clear that they will succeed even with a lot of money.
The probability is relatively minor, at least based on the information Linkcyst
currently has. Macrohard has not announced any plans, nor has the press reported any
such plans. Linkcyst has no reliable information that the market entry will occur, just
unconfirmed rumors. Given the weakness of this information, the probability that it will
happen must be discounted.
A low probability by itself does not keep something from being material, if the
magnitude is high enough. It’s unclear how any given court might balance these, but it
seems unlikely that a court would require Linkcyst to report unsubstantiated rumors,
without more. That in itself could be misleading. Therefore, it is unlikely a court would
find the omission of these rumors materially misleading.