1
Securities Regulation
Professor Bradford
Spring 2013
Exam Answer Outline
The following answer outlines are not intended to be model answers,
nor are they intended to include every issue students discussed. They
merely attempt to identify the major issues in each question and some
of the problems or questions arising under each issue. They should
provide a pretty good idea of the kinds of things I was looking for. In
some cases, the result is unclear; the position taken by the answer
outline is not necessarily the only justifiable conclusion.
I graded each question separately. Those grades appear on your
printed exam. To determine your overall average, each question was
then weighted in accordance with the time allocated to that question.
The following distribution will give you some idea how you did in
comparison to the rest of the class:
Question
Question
Question
Question
Question
Question
1:
2:
3:
4:
5:
6:
Range
Range
Range
Range
Range
Range
4-8;
2-8;
4-9;
2-8;
2-8;
2-9;
Average
Average
Average
Average
Average
Average
=
=
=
=
=
=
6.43
6.33
6.77
5.07
5.40
5.30
Total (of unadjusted exam scores, not final grades): Range 3.95-7.80;
Average = 5.86
All of these grades are on the usual law school scale, with 9 being an
A+ and 0 being an F.
If you have any questions about the exam or your performance on the
exam, feel free to contact me to talk about it.
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Question 1
Rule 504 is not available to Acme. Rule 505 could be available, but
only if the offering amount is limited to $2 million. Rule 506 could be
available for a $3 million offering. However, the current offering is
likely to be integrated with the prior Regulation A offering,
precluding the use of either Rule 505 or Rule 506.
Rule 504
Offering Amount
Rule 504 is not available for this offering. The offering amount of a
Rule 504 offering may not exceed $1 million, less the price of all
securities sold within the past 12 months that, among other things,
were sold pursuant to a section 3(b) exemption. Rule 504(b)(2).
Regulation A is a 3(b) exemption, and those sales were within 12
months of the proposed offering, so the $1 million limit is reduced by
the $3 million raised in the Reg. A offering, leaving less than zero.
Rule 505
Offering Amount
The offering amount of a Rule 505 offering may not exceed $5
million, again less the price of all securities sold within the past 12
months pursuant to a section 3(b) exemption. Rule 505(b)(2)(i).
Therefore, if Acme sells pursuant to Rule 505, the offering amount
may not be more than $5 million - $3 million = $2 million.
Number of Purchasers
There may be no more than 35 purchasers in a Rule 505 offering,
Rule 505(b)(ii), but accredited investors are not counted. Rule
501(e)(1)(iv). A natural person is an accredited investor if that
individual has a net worth, excluding the value of his principal
residence, of at least $1 million, or if the issuer reasonably believes
the individual has such a net worth. Rule 501(a)(5). Just having
people fill out a questionnaire is probably insufficient to establish a
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reasonable belief, so Broker and Acme need to do further work to
verify the net worth of those individuals. Assuming they do so, they
would be accredited investors and not count against the limit.
Information Requirements
Issuers must make information available to purchasers in a Rule 505
offering, but not if those purchasers are accredited investors. Rule
502(b)(1). If all of the purchasers are accredited investors, it won’t
have to comply with this requirement.
General Solicitation
Rule 502(c) prohibits general solicitation and general advertising in a
Rule 505 offering. Broker plans to solicit all 2,500 of its clients.
However, the SEC’s view is that soliciting investors with whom the
issuer or brokers assisting it have a preexisting relationship is not a
general solicitation in violation of Rule 502(c). Broker has a
preexisting relationship with all of the clients to be solicited, such the
solicitation does not violate Rule 502(c).
Rule 506
Offering Amount
Rule 506 does not limit the amount of the offering, so Acme may
raise the full $3 million.
Number of Purchasers; Information; General Solicitation
The restrictions on the number of purchasers, the information
requirements, and the prohibition on general solicitation are the same
as for Rule 505.
Sophistication Requirement
If any of Broker’s clients turn out not to qualify as accredited, Acme
can sell to them only if alone or with a purchaser representative, they
have “such knowledge and experience in financial and business
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matters that . . . [they are] . . . capable of evaluating the merits and
risks of the prospective investment” or Acme reasonably believes they
meet this requirement. Rule 506(b)(2)(ii). This requirement does not
apply to anyone who qualifies as an accredited investor. Id.
Integration
“All sales that are part of the same Regulation D offering must meet
all of the terms and conditions of Regulation D.” Rule 502(a). If the
earlier Regulation A offering is considered part of the current
offering—if the two are integrated—then neither 505 nor 506 would
be available. The Regulation A investors, members of the general
public, were probably not accredited investors, so including them
would exceed the 35-purchaser limit in both Rules 505 and 506. Rule
506 would also be unavailable because at least some of those
unaccredited purchasers would not meet the sophistication
requirement. Finally, the sales activity in the earlier offering would
violate the general solicitation restriction. In addition, integration of
the two offerings could retroactively destroy the prior Regulation A
exemption.
Integration Safe Harbors
The integration safe harbor in Regulation D does not apply because
the Regulation A offering was less than six months prior to the
current offering. See Rule 502(a). The only potentially applicable
integration safe harbor in Regulation A also requires at least six
months’ separation. See Rule 251(c)(2)(v).
The Five-Factor Test
In the absence of a safe harbor, a five factor test is used to decide
whether to integrate offerings. This test asks whether the offerings (1)
are part of a single plan of financing; (2) involve the same class of
security; (3) are made at or about the same time; (4) are for the same
consideration; and (5) are for the same general purpose. The
application of the test is uncertain; all five factors do not have to be
present for offerings to be integrated
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The two offerings are only five months apart, not far enough apart to
definitively show they are separate. They are for exactly the same
purpose—development of the milling machine. The same type of
consideration, cash, is received in both offerings, although most
offering are for cash so this is not a strong reason for integration.
They are technically different classes of security, but the only
difference between them is a dividend preference. Otherwise, their
rights are identical. This seems close enough to integrate them.
Finally, it’s arguably not a single plan of financing. At the time of the
first offering, Acme believed it needed only $3 million, and it did not
plan to do a follow-up offering. The second offering is needed only
because of the unexpected problems developing the machine.
However, since this is the only factor that clearly points against
integration, it is likely the two offerings will be integrated.
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Question 2
Founder’s letter appears to be an offer to sell in violation of section
5(c) of the Securities Act. No safe harbor is available to protect it.
Section 5(c) and “Offer to Sell”
Section 5(c) prohibits any offer to sell a security before a registration
statement is filed. The term “offer to sell” includes “every attempt or
offer to dispose of, or solicitation of an offer to buy” a security. §
2(a)(3).
Founder’s letter does not expressly offer to sell the Gamma stock or
even mention the offering, but an offer to sell can include
conditioning the market—“arousing public interest in the issuer or in
the securities of the issuer.” Securities Act Release No. 3844.
Founder’s letter, with its positive view of the company’s performance
and prediction of revenue and income increases, clearly could arouse
public interest in Gamma. Founder is just continuing to do something
he has done for the last five years, so his purpose arguably was not to
condition the market. But that is nevertheless the likely effect, and,
unless a safe harbor is available, there’s a significant risk the letter
would constitute an offer to sell.
Rule 433
The free-writing prospectus rule, Rule 433, is not available. It is
available only after a registration statement has been filed. Rule
433(a).
Rule 163A
Rule 163A is not available because the letter was not sent more than
30 days before the expected date of filing. Rule 163A(a).
Rule 168
Rule 168 is only available to reporting companies, Rule 168(a)(1), and
Gamma is not a reporting company.
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Rule 163
Rule 163 is only available to well-known seasoned issuers, Rule
163(a), and only reporting companies are well-known seasoned
issuers. See Rule 405 and Form S-3.
Rule 134
Rule 134 is only available after the registration statement has been
filed. Rule 134, first ¶. Here, the registration statement has not yet
been filed.
Rule 135
A Rule 135 notice may include only the information specified in Rule
135(a)(2). None of the information in the letter—the report on past
performance or the projections of future revenue and income —fit
within (a)(2).
Rule 169
Rule 169 is not available. It is not limited to reporting companies, but
it only allows the communication of “factual business information.”
Rule 169(a). The term “factual business information” includes
“factual information about the issuer, its business or financial
developments, or other aspects of its business,” Rule 169(b)(1)(i), or
“advertisements of, or other information about, the issuer ’s products
or services.” Founder’s discussion of Gamma’s past performance
probably is factual business information, but his prediction of its
future performance is not. Compare Rule 168, which distinguishes
“factual business information” and “forward-looking information.”
See Rule 168(b). These future projections are forward -looking
information, and therefore not allowed by Rule 169.
In addition, the condition in Rule 169(d)(3) is probably not satisfied.
The question doesn’t say who the letter was sent to. If it was sent to
Gamma’s shareholders, it was clearly directed to investors. Even if it
was just released to the press or on a web site, the performance
information provided clearly seems aimed at investors.
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Question 3
An investment contract is (1) an investment of money (2) in a
common enterprise (3) with an expectation of profits (4) to com e
from the efforts of others. SEC v. Howey.
The game itself is not a security, but a consumption item. See United
Housing Foundation v. Forman. People are simply paying $5,000 for one
of the games. If buyers purchase only the game, there will be no
common enterprise—either among investors or between investors and
VSI. And any profits earned by the game buyers will result solely
from their own efforts, with no involvement by VSI. However, the
leaseback/servicing arrangement is probably an investment contract.
1. Investment of Money
Those who elect the servicing arrangement are investing $1,200, with
the hope of a return on that investment.
2. Common Enterprise
The lower courts disagree about the meaning of the common
enterprise requirement. Some of them require horizontal
commonality—a pooling of investor funds. Each investor’s game is
separately placed and serviced, but there still may be horizontal
commonality. VSI is not going to have a separate servicing
department and handle billing and service separately for each
investor. Instead, presumably, the $1200 payments are going to be
pooled and that pooled money used to pay for maintenance, sales, etc.
Sharing of profits is not required for horizontal commonality, as long
as investors’ funds are pooled.
In jurisdictions in which it is sufficient, there clearly is a vertical
common enterprise, even in the strict sense. There is a direct
relationship between the success of the promoters and that of the
investors. Investors will not receive their payments unless the
promoter is able to generate enough cash flow from games, and the
promoter’s profit also depends on how well the games do.
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3. Expectation of Profits
There clearly is an expectation of profits from the leasing of the
games. The game owners will receive $125 a month. It doesn’t matter
that the promised return is not a percentage of the profits generated;
a flat fee is sufficient for there to be an expectation of profits. SEC v.
Edwards.
4. Efforts of Others
The final question is the efforts of others part of the test. Howey said
the profits expected must come “solely” from the efforts of others,
but later cases have moderated that requirement. The question is
whether the significant efforts, the essential managerial efforts that
affect the success or failure of the enterprise, are to be made by
someone other than the investor. This requirement appears to be met.
VSI will be locating a client for each game, installing the game,
servicing it, and collecting revenues. The game owners have a veto
over the placement of the games and, as bar owners themselves, they
might have enough knowledge for that veto to be meaningful . But
profitability depends on more than just the initial location of the
games, and all of the management decisions after that initial choice
will be the promoter’s. It’s a close question, but the primary efforts on
which profits depend are probably those of VSI.
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Question 4
Materiality
It is unclear if the omitted information was material. An omission is
material if there is a substantial likelihood that a reasonable
shareholder would view it as important, as having significantly
affected the total mix of information. TSC Industries.
The omitted information involved a potential 10% reduction in the
merger consideration, which seems significant. However, at the time
of the statement, it was uncertain if the price reduction would occur;
it was an uncertain future event. The determination o f materiality
must be made by balancing the probability that the price reduction
would occur with its magnitude if it did occur. Basic v. Levinson.
The magnitude is a 10% reduction in the price paid to Zappa ’s
shareholders. The probability of that occurring was probably
relatively low at the time of the press release. At the time of the
statement, many economic analysts thought that it was unlikely the
Euro would decline, much less decline by 5%. Thus, we have a
moderate magnitude and a relatively low probability; it’s unclear if
this combination would be sufficient to make it material.
Safe Harbor for Forward-Looking Statements
The safe harbor for forward-looking information is in section 21E of
the Exchange Act. Zappa, an issuer subject to the reporting
requirements of the Exchange Act, is potentially protected by that
safe harbor. See Section 21E(a)(1).
Forward-Looking Statement
To be protected by that safe harbor, the allegedly misleading
statement must be a “forward-looking statement. It’s not clear that
this is a forward-looking statement within the meaning of section 12E
of the Exchange Act. On the one hand, the statement relates to “the
plans and objectives of management for future operations,” Section
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21E(i)(B), the proposed merger. But, on the othe r hand, the omission
concerns what is in the signed contract, a historical fact. However,
the contract provision in question itself focuses on the future —the
possible future price reduction—so it could qualify as forwardlooking.
The safe harbor protects the defendant in three circumstances. The
first is if the misstatement is immaterial. Section 21E(c)(1)(A)(ii).
This adds nothing to the previous analysis of materiality. The second
is if the plaintiff fails to prove that the statement was made with
knowledge by the officer approving the statement that it was false or
misleading. Section 21E(c)(1)(B)(ii). Zappa’s CEO intentionally
omitted mention of the price adjustment clause, so this won’t protect
Zappa. But most of the appellate courts have held that a d efendant
may use the other portion of the safe harbor to protect even a
knowingly misleading statement, so the third safe harbor might still
help.
Requirements of the Safe Harbor
Zappa is protected from liability under the third prong of the safe
harbor only if the statement is identified as a forward-looking
statement and it includes meaningful cautionary statements
identifying important factors that could cause actual results to differ
materially from those in the forward-looking statement. Section
21E(c)(1)(A)(i). The press release specifically says it contains
forward-looking statements, so the first requirement is met. But it
only identifies one specific factor that might cause the shareholders
not to receive $50 a share—the shareholder approval requirement.
Otherwise, it just says “contingencies,” which seems too general to be
a “meaningful cautionary statement.”
The statement need not identify all factors that might cause results to
differ materially; it does not even have to identify the particular f actor
at issue, in this case the price adjustment clause. See Asher v. Baxter
International. But is it sufficient to identify specifically only one factor
that might cause the results to differ?
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Zappa’s Knowledge
Reliance
Plaintiff clearly did not rely on the misstatement when he purchased
the stock. He was not even aware of the press release or the pending
sale. However, Zappa’s shares are traded on the New York Stock
exchange, and the market for Zappa’s shares is probably efficient.
Plaintiff may therefore rely on the fraud-on-the-market theory. Basic v.
Levinson. The press release was public information for three days
before Plaintiff purchased and, if the information was material, it
affected the market price at which Plaintiff purchased. Therefore,
unless Zappa can show that the market was aware of the truth,
Plaintiff has shown sufficient reliance for purposes of Rule 10b -5.
Loss Causation
As it turned out, the merger went through and Plaintiff received the
$50 per share consideration promised in the press release. The price
adjustment clause therefore did not affect Plaintiff. However, Plaintiff
can still show a loss caused by the omission. Plaintiff must show that
the price was inflated at the time of purchase because of the fraud
and that it subsequently fell due to the corrective disclosure. Dura
Pharmaceuticals.
When the truth about the adjustment clause became public, the price
of Zappa’s shares dropped to $46.50. Unless some other event
accounts for this drop, this must have been due to the disclosure of
the truth. Thus, if the original press release had included this
information, the price drop would have occurred before Plaintiff
purchased, and Plaintiff would have paid only $46.50. He has lost
$1.50 a share because of the fraud.
But Plaintiff ultimately received $50 a share for his stock. If he sells
for more than his purchase price, but for less profit than he would
have had absent the fraud, is that a “loss” under Dura?
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Question 5
If Smith is not an affiliate, he is free to sell the shares without
restriction. Smith is probably an affiliate and, if so, he still may use
Rule 144 to sell the shares, subject to a number of conditions.
Is Smith an Affiliate?
The answer to the question turns on whether Smith is an affiliate of
Omega. One is an affiliate of a company if, among other things, one
controls that other company. Rule 144(a)(1). Control means the direct
or indirect power to direct or cause the direction of the management
and policies of the company. Rule 405.
Smith owns 25,000 of Omega’s 100,000 shares and no one else owns
more than 5,000 shares, As a result, Smith was able to nominate 3 of
7 directors. That is probably sufficient to constitute control, even
though Smith doesn’t own a majority of the stock. Therefore, Smith is
probably an affiliate.
If Smith is an Affiliate
If Smith is an affiliate, he must comply with all the conditions of
Rule 144. Rule 144(b)(2).
Public Information
For a non-reporting issuer like Beta, there must be publicly available
the information concerning the issuer specified in certain paragraphs
of Rule 15c2-11. Rule 144(c)(2). We don’t know exactly what
information is available on Beta’s web site, but if it includes all the
required information, this requirement would be met. If not, Smith
could not resell the shares under Rule 144.
Holding Period
These are restricted securities, since they were subject to the
Regulation D resale limitations. Rule 144(a)(3)(ii). Therefore, the
holding period requirement in Rule 144(d) applies. Rule 144(d)(2)
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says that, for a non-reporting company, a minimum of one year mus t
elapse between the date of the acquisition of the securities from the
issuer or an affiliate of the issuer and Smith’s resale. Here, the shares
were originally acquired from the issuer 18 months ago. Unless one or
more of the smaller shareholders Smith acquired the shares from was
an affiliate (for instance, because he or she was a director), the 144(d)
holding period is met. Smith can sell the shares without any
additional restrictions.
Amount Sold
If Smith is an affiliate, the amount of shares Smith can sell in any
three month period is limited. This would include the 100 shares
Smith sold to Jones two months ago. The limit is the greater of 1% of
the shares of the class outstanding (1% of 100,000 = 1,000 shares) or
the average weekly volume of trading. Rule 144(e)(1). Only 100 Beta
shares have changed hands in the last month, so the former is clearly
the higher number. Since Smith has already sold 100 shares, he can
only sell an additional 900 shares immediately. He must wait to sell
more.
Brokers’ Transactions
The shares must be sold in brokers’ transactions, Rule 144(f)(1)(i), or
in other ways that don’t apply here. Broker’s plan to solicit all of his
customers would not be allowed. It would violate Rule 144(g)(3),
except for any customers who have indicated an interest in Beta stock
in the last 10 business days.
Notice of Sale
If the aggregate sales exceed $50,000 during any period of three
months, Smith would have to file a notice for the sale with the SEC.
Rule 144(h). [There’s an alternative limit of 5,000 shares but, as
previously explained, Smith can’t sell that many shares in a threemonth period.
If Smith is not an Affiliate
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If Smith is not an affiliate, he only needs to comply with the holding
period in Rule 144(d), since Beta is not an Exchange Act reporting
company. Rule 144(b)(1)(ii). The analysis of the holding period is the
same as above. As previously discussed, the applicable holding period
has probably expired.
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Question 6
Delta may hyperlink to the analyst’s report only if it complies with
the conditions of Rule 433.
Section 5(b)(1)
It is unlawful for Delta to transmit any prospectus after the
registration statement has been filed unless it meets the requirements
of section 10. Securities Act § 5(b)(1). Delta has already filed a
registration statement, so section 5(b)(1) applies.
Is Delta Transmitting the Report?
If the analyst’s report is a prospectus, the posting of the hyperlink by
Delta would be the transmission of a prospectus by Delta. A hyperlink
on the issuer’s web site to an offer on a third party’s web site
constitutes an offer by the issuer unless otherwise exempted from
5(b)(1). Rule 433(e)(1).
Is the Report a Prospectus?
General Definition
The report would probably be a prospectus. The term “prospectus”
includes a written communication that “offers any security for sale.”
Securities Act § 2(a)(10). This report is written because the term
“written” includes a “graphic communication,” 2(a)(9), and the SEC
has defined graphic communication to include Internet web sites.
Rule 405. It is also an offer to sell. A communication that conditions
the market or arouses public interest in the issuer or its securities is
an offer to sell. Securities Act Release No. 3844. The favorable
information about the issuer in the analyst’s report, tied to
information about the upcoming offering, is likely to condition the
market.
Possible Safe Harbors
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The SEC has adopted several rules that say certain communications
will not be considered an offer to sell, but none o f them apply here.
Rules 168 and 169 expressly prohibit any mention of the offering. See
Rules 168(c), 169(c). Rules 137, 138, and 139 protect research reports
such as the one here, but they only allow publication and distribution
of the report by broker-dealers, see Rule 137(a), 138(a), 139(a), not
their redistribution by the issuer. Rule 163A does not apply because
the registration statement has already been filed. Rule 163 is only
available to well-known seasoned issuers, and applies only in the
context of section 5(c). Rule 163(a). And both Rules 134 and 135
seriously limit what may be included in the communication. The
analyst’s recommendation is not one of the things allowed by Rules
134(a) or 135(a)(2).
Does It Meet the Requirements of Section 10?
Rules 430 and 431 Do Not Apply
It is unlawful to transmit a prospectus only if it does not meet the
requirements of section 10. Section 5(b)(1). Both the preliminary
prospectus and a summary prospectus meet the requirements of
section 10. See Rule 430(a); Rule 431(a). But this report is neither of
those.
Rule 433
A communication that complies with Rule 433 meets the
requirements of section 10. Rule 433(a).
Delta is eligible to use Form S-3, so this communication falls within
Rule 433(b)(1), and the requirement in Rule 433(b)(2) that the
communication be preceded by a preliminary prospectus does not
apply.
The communication must, however, meet the other requirements of
the rule.

Nothing in the report may conflict with either the registration
statement or Delta’s filed Exchange Act reports that are
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

incorporated by reference into the registration statement. Rule
433(c)(1).
The page on which the hyperlink appears must incl ude the
legend required by Rule 433(c)(2)..
The report is an issuer free writing prospectus since it was
referred to by the issuer. Rule 433(h)(1). Therefore, Delta must
file the report with the SEC. Rule 433(d)(1), (e)(1).