Securities Regulations Outline Haft Spring 2oo6

INTRODUCTION
1. GOALS OF SECURITIES REGULATIONS a. Consumer Protection i. Following sock market crash of 1929, congress saw two main problems 1. Investors were vulnerable in a manipulated marketplace 2. The lack of confidence in the markets prolonged the depressions ii. Today, the need for consumer protection is greater because a much higher percentage of the public invests b. Informational needs of investors i. Because of complexity of securities market, much more information is needed than in other markets ii. Haft says this is most important securities laws were designed to provide full and fair disclosure for investors and the marketplace Allocative efficiency i. Theory says that federal securities laws ensure the accuracy of security prices meaning stock prices confirm to the fundamental value of the companies traded ii. Disciplines poorly managed firms and rewards efficiently managed firms Corporate governance and Agency costs i. Argue purpose of the securities laws should be to reduce the SHs cost of monitoring corporate officers by mandating disclosure of the use of corporate assets by managers. Economic Growth, Innovation and Access to Capital i. Economies that are stock market based allow greater entry into the market, incouraging innovation and increasing competition.

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SECURITIES TRANSACTIONS: a. Issuer Transactions (Primary Market): i. Sales of securities by the issuer to investors ii. Means of raising capital iii. Public offering/Primary distribution/IPO 1. Selling efforts of a large amount of securities to the public 2. usually occurs through syndicated broker-dealers called underwriters iv. Private placement 1. Most expedient and get special regulation exemptions1 b. Trading Transactions (Secondary Market) i. Purchasing and selling of outstanding securities among investors (not the company) ii. Existence of a secondary market is critical to capital raising in the US 1. Secondary markets provide liquidity to investors which in turn invigorates primary markets. iii. Either privately negotiated or through public markets iv. Division of Security markets: bond, equity markets and derivative/options Two Kinds of Secondary Trading Markets i. Exchange Market: auction market 1. How it works: a. Only Members (Brokers) may trade on a stock exchanges floor, either for their own accounts or for customers. Limited number of members can trade, so their seat has value b. Specialist: a category of exchange member firms where the specialist is assigned one stock to trade and broker who wishes to trade will go to the specialist 2. NYSE

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ii. Over the counter Market: dealer market 1. How it works a. Investor buys or sells in a transaction with the dealer, who quotes a bid/asked spread, with the dealer making money on the spread between the prices b. Transaction can also be with a broker who buys from a dealer and charges you a commission 2. NASDAQ (National Association of Securities Dealers Automated Quotations) a. Usually cos with smaller capitalization and computer and tech firms 3. Differences between OTC and Exchange Markets (See other outline un-important) 3. THE LEGAL FRAMEWORK OF SECURITIES REGULATION a. The Securities Act of 1933 (focuses primarily on issuer transactions) i. Goal: full and fair disclosure and prohibit fraudulent sale of securities 1. To provide investors with material financial and other information concerning new issues of securities offered for the sale to the public. 2. This is done through the registration statement which produces the prospectus, which provides all material information necessary to assess the merits of their purchase. ii. Covers: The issuance of securities to public investors by 1. requiring the filing of a registration statement; 2. mandating the dissemination of a disclosure document [prospectus] 3. and enacting liability scheme for misinformation or omitted information in the registration statement, prospectus, or during the distribution of new securities to public investors iii. Disclosure only statute: 1. Not a substantive, regulatory, paternalistic statute. However, there is significant enforcement behind it. Most onerous civil liability statute on the books. The Securities and Exchange Act of 1934 i. Requires continuous disclosure for companies required to register under its provisions (and restrict and penalize insider trading ii. Three categories of reporting companies 1. Companies that have securities listed on a national exchange ( 12(b)) 2. Companies that have assets in excess of $10 million and have a class of equity securities held by at least 500 persons (12(g) and Rule 12(g)(1)) 3. Companies that have filed a 33 Act registration statement that has become effective iii. Forms required to be filed 1. Annual report (10-K): extensive description of the companys business and audited financials + managements discussion and analysis of position and performance 2. Quarterly report (10-Q): un-audited interim financial statements + managements analysis of financial operations and conditions. 3. Material developments (8-K) iv. Reporting companies must also comply with proxy rules of 14(a) v. Williams Act and Tender offer disclosures: Requires outsiders to make disclosures when 5% of a class of registered securities is or will be owned as a result of a tender offer c. Sarbanes Oxley i. Broad prescriptions for corporate governance: authorizes SEC to develop rules for professional conduct for lawyers: regulates areas that used to fall under state regulation. Blue Sky Laws i. State securities laws 1. Not exclusively disclosure oriented like federal laws: often into merit regulation standard whereby qualification depends on substantive merits of the offering ii. Not uniform, but 18 of Securities Act exempts covered securities from states registration

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THE 33 ACT REGISTRATION STATEMENT; MANDATED DISCLOSURE; DISCLOSURE GENERALLY

A. PRELIMINARY CONSIDERATIONS
1. Advantages of going public a) Raise funds for corporate purposes like increasing working capital, expanding plant b) If a secondary offering is included, the selling shareholders may cash in on part of their investment. c) May gain prestige, become better known and obtain wider market. d) Better position to acquire other businesses through issuance of stock instead of cash. e) Permits adoption of stock option plans. f) Give owners sense of financial success and liquidity Disadvantages of going public a) High expense of maintaining a public company. b) Full disclosure obligations of reporting companies with respect to salaries, transaction with mgmt, conflict of interests, etc. c) Loss of flexibility in mgmt arising from practical, if not legal limitations on salaries and fringe benefits. d) Increased cost of administration and accounting due to reporting requirements of 34 act. e) Possible loss of control over dividend policy. f) Business decisions dictated by short-term fluctuations in stock price. g) May become target of takeover bid. h) Shares may sell at lower price than anticipated. Going Public: Practice, Procedure and Consequences p. 189 a) Article covers the practice and procedure of going public in a step by step analysis order: 1) Selection of underwriter: important decision of deciding between prestige, or specialty, or other factors that must be uniquely appropriate to deal. (a) Managing underwrite will take lead in forming the underwriting syndicate. (b) Underwriter will provide after-market support for the security being sold. (c) Assist in getting other forms of financing as well. 2) Structure of offering (a) Questions of whether to offer common stock, convertible debt, warrants. (b) Consider number of shares offered and the offering price for the shares. 3) Preparing the registration stmt (a) Usually quarterback is the company attorney who drafts documents and performs due diligence. (b) Lawyers have a duty to make sure reg stmt is accurate. 4) Underwriting agreement (a) Company signs a letter of intent with managing underwriter detailing terms. 5) Timetable (a) Average first offering takes 2-3 months Common disclosure pitfalls a) Cover page 1) Trend is to include an at glance description of transaction. 2) Item 501(c) of Regulation S-K calls for a concise sketch of the terms of the offering. 3) Reg stmts that omit pricing info in reliance on Rule 430A must include price range on cover page. b) Summary Information 1) Length and complexity of prospectus usually result in a summary provided under Item 503(a) of Reg S-K. 2) Must do a balanced presentation featuring favorable and unfavorable info. c) Risk Factors 1) Item 503(c) of Regulation S-K calls for discussion of principal material risk factors. d) MD&A 1) Intended to give investors an opportunity to look at the issuer through the eyes of management. 2) Address economic and business conditions 3) Item 303 of Regulation S-K adopts a more inclusive disclosure criteria than the Basic test - meaning that should disclosure even only a chance of being material. e) Business 1) Item 101 of Regulation S-K requires disclosure of general business developments of the issuers business.

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4) Kronfield v. TWA: Magnitude of an outcome with low probability of occurrence (a) TWA Issued prospectus that discussed at length TWAs relationship with its parent TWC. When prospectus was issued TWC asked Goldman sachs what its financial options were with regard to TWA and 1/7of the options was to terminate the P/S relationship. Held That materially misleading for prospectus not to disclose that termination of TWC was under consideration. (b) exemplifies idea that magnitude of an outcome with low probability of occurrence can also dominate the materiality determination. Here, the tremendous effect the termination of TWA as a subsidiary would have on the value of the parent companys stock overwhelmed the courts consideration of slight probability of event happening. 5) Note on Duty to disclose: Need a duty (a) A corp is not required to disclose a fact merely b/c it is material, rather an omission is actionable under the securities law only when the corp is subject to a duty to disclose omitted fact (b) 33 Act context: Rule 408 requires that material facts be disclosed throughout the offering process (c) 34 Act Context: See duty to update and correct below. 6) Problem 11-2 (574) (a) Completing form 10K and describe firms only plant and its most valuable asset as located in a particular location and being owned in fee simple. (This item is responsive to item 102 of Regulation S-K which requires a brief description of the property and to tell if it is held subject to an encumbrance). Just found out need 3 more months to get adverse possession (b) Dont disclose though magnitude would be huge for company in totality if other company finds out, probability is so low + if find out then you lose property anyway. (c) Though under TWA case the encroachment could be considered a material fact 3. TRUTH ON THE MARKET: TOTAL MIX OF INFORMATION AND MARKET EFFICIENCY a) Generally: 1) Securities investors do not depend exclusively on mandatory disclosures. Due to ECMH info that is already known to the market is not actionable, even if material so question is would this nondisclosed fact alter the total mix of info that is available. 2) It is even possible for misleading disclosures not to be material if professional securities traders who set the market price know the disclosures to be wrong (Wieglos). b) Wieglos v. Commonwealth Edison Co.: Truth on the Market and TOTAL MIX PRONG (Efficient Markets) 1) Edison, an S-3 corp sold stock on the shelf. 10 The succinct RS incorporated other filings by reference. These documents incorporated by reference estimated the total costs of building its nuclear reactors. After the sale regulators gave Edison trouble in obtaining its licenses for the reactors (delays cost a lot) and ordered one to be dismantled. The stock price fell as a result and P, a purchaser of the shelf offering, files suit under 11 and demanded the amount the securities declined.11 They argued that the 2) Issue: whether the cost projections were misleading or whether the truth of their projections were on the market and incorporated into stock price 3) Held: The sales projections cannot be the basis of liability. Though the incorporated documents were erroneous, this was S-3 company that had many analysts following it who knew that the company increased its estimated costs every year as the result of delays and newspapers reported this & Market price in Ps stock reflected this (ECMH). (billy the projections did not alter total mix of market) c) In re Apple Computer Sec. Lit. 1) Statements that new computer sales were going to be huge were offset by more sober analysts reports, but statements about the products capabilities were within the manufactures knowledge so if misleading they would be ground for liability b/c not offset by info already in the public.

d) United Paperworks International 1) Co said proxy statement was not misleading because the omitted facts were in a 10K that were reported by
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The SEC believes that markets correctly value the securities of well followed firms, so that new sales may rely on information that had been digested and expressed in the securitys price. Firms eligible for Form S-3 also may register equity securities for the shelf under Rule 415(a)(1)(x). Shelf Registrations allows the firm to hold stock for deferred sale. Info in the registration statement will be dated by the time for sale, but the SEC believes that the market price of large firms accurately reflects current information despite the gap between registration and selling dates. This has to be a 11 claim because they did not sell their securities so there would be no loss, just a potential loss

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P normally need not prove reliance and the 11(a) exception 1) No reliance: No requirement that P show any type of reliance on the RS or the statutory prospectus much less show reliance on the actual falsity or omission. 2) Unless: person has acquired the security after the issuer has made generally available an earning statement covering a period of at least one year beginning after the effective date of the RS Even then, reliance may be proved without ever reading the RS. 11(a)

d) No Causation or Injury required 1) Policy of 11: (a) deterrence rather than just compensation is the goal, so even someone who was completely unaware that the securities were part of the public distribution has standing 2) Damages reduced by causation: (a) Damages are reduced to the extent D proves damages resulted from the material misstatement or omission in the RS. 11(e) e) f) P Need not show intent on the part of the D Requirements for complete 11 action 1) Effective RS 2) Material misstatement or omission 3) Purchased through RS in question 4) Sue everyone on the list

B. SECTION 11 DEFENDANTS15 1. 11 defendants need not be in privity with the Purchaser and need not have actually created or disseminated the challenged information. 2. Those who signed the RS: Form S-1, Signatures (Follows Item 17) Instruction 1 a) Registrant b) Principal executive officers or officer (CEO) c) Principal financial officers (CFO) d) Its controller or principal accounting officer e) At lease a majority of the board or persons performing similar functions f) If foreign registrant: must be signed by its authorized US rep g) If limited partnership: Must be signed by a majority of the board of directors of any corp gen partner signing RS 3. Directors (or persons performing similar functions) or partner at the time of filing 4. Every person who, with consent, is named in RS as being or about to become a director or partner 5. Every Expert who consents to his opinion in RS a) i.e. accounting firm that audited financials b) Note: Expert liability is limited to info prepared and certified by her 6. Every underwriter16 7. 15 Control persons a) an person who controls any person liable under 11 or 12 shall also be liable jointly and severally with and to same extent as such controlled person. b) Unless the controlling person had no knowledge of or reasonable grounds to believe in the existence of the facts by reason of which liability of the controlled person alleged to exist. C. DEFENSES TO SECTION 11 CLAIM GENERALLY a) Issuer has no defense (w/ exception) 1) Issuer is strictly liable regardless of its knowledge or negligence 2) Except issuer has defense of showing that P knew of the untruth or omission at time of purchase b) Non issuer Defendants (Have burden of proof) 1) Due Diligence: Have burden of proof to show their nonculpability 2) Whistleblowing: can always escape liability if you resigned and informed the SEC and the issuer in writing that you are not responsible for statements in the RS. 11(b)(1)-(2)

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THIS IS EXCLUSIVE FOR TEST: NO AIDERS & ABETTORS

Remember that there is an expansive definition of UW to include those directly or indirectly participating in the UW under 2(a)(11). See Harden (holding a UW that performed due diligence on RS but did not purchase or sell, to be a 11 D).

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UNDERWRITER DILIGENCE IN CONTEXT: ISSUES W/ SHELF REGISTRATION: ARE WE LOSING THE GATEKEEPER? a) Though Underwriters serve as gatekeepers the problem of its due diligence investigation is accentuated in the case of the UWs participation in offering that was registered for shelf b) Rule 415 Shelf Registration and Automatic Shelf Registration reforms (handout 11-12):21 1) Allows S-3 corps to File one short form RS for all future securities that may be offered in 2 year period; with reforms you can shelf register unlimited amount and have to renew it every 3 years 2) Purpose: reduce costs and allow access to favorable market conditions + SEC passed in order to make US UWs more competitive to foreign markets. 3) Why for S-3: because of steady stream of info c) The mechanisms of incorporation by reference and Shelf registration 1) Significantly reduced the time and expense necessary to prepare public offerings thus enabling more rapid access to capital 2) This effected time UWs could perform their investigations of issuers and raised concerns about ability to undertake a reasonable investigation with respect to info incorp by reference. d) Competitive bidding and reduced incentives to conduct costly due diligence before being picked: 1) In Shelf registration offering under Rule 415, issuer picks UW after reg statement becomes effective and therefore gets UWs on competitive basis -- reduces incentive to launch expensive investigation of issuers RS e) Problems Created by Rule 415 1) Inadequate disclosures: more of concern relating to integrated disclosures (a) Also remember that quality of Shelf Registration is much less than a full RS. Filing a 10K does not subject issuer to 11 liability. 2) Insufficient due diligence: (a) With shelf there is fast time schedules, Some say UW cannot afford to devote time and expense necessary to conduct due diligence review, especially on documents that are incorp 3) Others say UWs do new due diligence by having continuous diligence programs, with periodic due diligent sessions 4) In recognition SEC passed Rule 176 f) Rule 176 May provide Protections to UWs (it was adopted pursuant to concerns like these see above)22 1) 176(g) allows to consider the type of UW for reasonable invest 2) 176(h) allows for consideration where fact misrepresented was incorporate by reference and whether particular party was responsible for the document

g) But See Worldcom, Inc Securities Litigation: UWs Due Diligence obligations in Shelf Registration & 176 1) Worldom Execs manipulated companys filings, which were incorporated by reference into the RS. UWs argued they were entitled to rely without further investigation on Worldcoms Financial statements audited by Arthur Anderson as well as comfort letters from the auditor. 2) Held that SEC did not intend to alter UWs due diligence obligations and SEC rejected considerations of competitive timing and pressure when evaluating the reasonableness of UWs invest. (a) SECs intent was to maintain high standards through the use of new strategies that were equally thorough: these would have to be anticipatory and continuous due diligence programs (reservoir of info) 3) Court notes that practitioners feel current regime of liability for UWs under 11 no longer makes sense: Thus practioners call for reexamination of UWs liability under 11 (and 12(a)(2)) since 1933 and 34 assumptions about issuers working with UWs in leisurely atmosphere are at odds with todays competition by multiple UWs for high speed transactions. 4) Hafts Notes on Worldcom (a) Worldcom was one of the largest companies and due diligence is extremelely limited (b) Court said cannot rely on financials because there was a red flag Haft says the fraud was simple but impossible to detect (even Arthur Anderson couldnt detect it) (c) SEC tried to bring due diligence up to date with Rule 176 but judge said no (d) In practice UWs and Lawyers ignore this, they cannot possibly do what she says (e) This was reasonable position for UWs in light of new Shelf registration (after opinion SEC passed automatic shelf)

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For more on Shelf registration see supplemental info Not very strong argument because only says relevant circumstances

CIVIL LIABILITY CONTINUED

A. SECTION 12 LIABILITY
1. DIFFERENCES FROM 11 a) Application 1) 11 applies to material misstatements in RS, while 2) 12(a)(1) applies to securities sold in violation of 5 3) 12(a)(2) takes over where 11 left off, and allows purchasers in an offering to seek rescission from sellers if the offering was carried out by means of prospectus or oral communication (i.e. public offering 10 prospectus) that is materially false or misleading29 b) Privty: 1) 12 requires privity between the buyer and the seller - only immediate purchaser can sue immediate seller c) Defendants 1) 11 statutory Ds 2) 12 Only the people who offer and sell the securities (i.e. not directors etc..) d) Damages 1) 11 damages and very defined 2) 12 Can sue for rescission or for damages e) Defenses under 12 1) 12(a)(2) says nothing about reasonable investigation (but it does require reasonable care see below) 2) 12(b) allows the D to reduce the amount recoverable under 12(a)(2) by proving that the depreciation in value of the security was not caused by the material misrep or omission called loss causation defense SECTION 12(a)(1) a) Generally 1) Section 12(a)(1) provides that any person who offers or sells a security in violation 5 shall be liable to the purchaser for (a) Rescission when securities still owned: the consideration paid (with interest) less the amount of any income received on the securities or (b) Damages if purchaser no longer owns: difference between the price paid and the amount received by the P on the security before the suit was brought b) Typical violations that trigger (Liability is absolute for any violations of 5) 1) Sale of unregistered security 2) Failure to deliver prospectus 3) Making illegal offer in pre-filing period c) P does not need to show 1) intent (this is strict liability 2) Injury (the goal is deterrence) d) All P needs to show 1) Violation of 5 2) Interstate commerce 3) P made adequate tender of the security if it is still owned 4) The action has been brought within the time state din the SOL. See 13 e) Person must be a seller (or offeror) but who is a Seller for purposes (Pinter v. Dahl) 1) The Person who actually passes title 2) The person who solicits the purchase (for their own personal gain or financial interests of owner) f) Pinter v. Dahl: Who is a seller for purposed of 12(a)(1) 1) Printer (D) met with Dahl (P), about investing in oil and gas leases in private offering. Dahl solicited some of his friends to purchaser shares, b/c he felt it was a good investment. When the venture failed, Ds brought suit seeking rescission under 12(a)(1) (they did not qualify for private offering). Printer (P) counter claims, seeking contribution from Dahl (D) alleging among other things that Dahl was a seller 2) Issue: Does liability under 12(1) extend to a person who urges the purchase of a security but whose motivation is solely to benefit the buyer? 3) Definition of a seller (a) The language of 12(a)(1) contemplates contractual buyer-seller privity.

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Haft says for sticker disclosures may be able to sue under 12(a)(2) and not under 11

3) Potential reach of this case is huge 4) Note on face to face transactions: in Marine Bank v. Weber court held that a unique agreement, negotiated on a face-to-face basis is not a security. 5. HOWEY TEST FACTORS a) Investment 1) The investment can be of Cash or noncash consideration, is expected to produce income; the buyer is not buying a consumable commodity b) Commonality/Common enterprise (Split over horizontal or Vertical): there a few different approaches for analyzing whether there is common interest among investors. A common enterpirse is one in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties. 1) Horizontal (more restrictive): Multiple investors have interrelated interests in a common scheme (requires pooling of investors funds so all investors are sharing in the same pool) (a) Usually a pro-rata distribution of profit (b) Cannot involve single investor (but see Lauer) (c) Wals v. Fox Hills Development Corp. (127, 7th 1994) Facts: p bought a time share interest in a golf course condo and entered into agreement with developer to rent the unit on behalf of p. Holding: court held no common enterprise because investors are not obtaining the same thing, an undivided share in the same pool of assets. Rather, their investment was in a specific apt differing from others (d) SEC v. Lauer (131, 7th 1995) court found that an investment in high-yield securities was a security even though only sold to a single investor. Rejected argument that because only single investor, no horizontal commonality. Seems the intention to involve multiple investors can result in horizontal commonality (e) Critics: some argue that requirement of horizontal commonality is formalistic and lacks any relationship to the policy goals of 33 act 2) Vertical: whether the activities of the promoter are controlling factor in success or failure of the investment. Some courts say it is sufficient if a single investor has a common interest with the manager of his investor (a) Common Enterprise may exist even though no pooling of investors funds or interests (b) Broad vertical: a common enterprise when activities/efforts of promoters are the dominant factor in the investments success, though no pooling of interests (direct relationship between promoters efforts and investors success) (c) Strict Vertical: requires that the fortune/success of investors be tied to the fortune of the promoter, rather than just the efforts (i.e. promoter and investors share risks). (d) Haft says only place where vertical has bite is trading accounts -3) Example: Discretionary trading accounts managed by brokers (a) Broad vertical: common enterprise may exist b/c of dependence on the expertise and efforts of the broker for profit even if promoter doesnt share in risk (b) Strict Vertical: no common enterprise if the promoter can continue to profit through commissions, even though investor is losing (c) Horizontal: may deny security status to these arrangements b/c multiple investors are not joint investors in the same investment enterprise so no pooling of funds c) Expected Profits: 1) Expected returns must come from earnings of the enterprise, not merely additional contributions and this return must be the principal motivation for the investment 2) This return must be the principal motivation for the investment not consumption (a) Where buyer is motivated by a desire to use or consume the item the securities laws do not apply. (United) d) Profits through Efforts of Others: Must be profits predominantly through efforts of others. 1) Howey holds that profits must be derived solely from effort of others 2) Lower courts have accepted that the investors efforts in common enterprise may contribute to profits as long as the mangers efforts predominate (so can participate a little but not too much) (a) Courts made change recognizing promoters could circumvent the securities laws by merely requiring investors to nominally participate (b) SEC v. Turner: said that the critical inquiry is not literally the sole effort of others but whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise (c) Animal Breeding Case: Miller v. Central Chinchilla Group: Pyramid selling: Raise chinchillas and promoters would resell. 8th circuit disregarded the efforts actually expended by investors and focused on the promoters representations to potential investors that only minimal efforts would be required to care

mature within 9 Months (b) 3(a)(10) (SEA 34) Excluded from the definition of security any note that matures within 9 months. See also 3(a)(10) of 34. * double check this (c) Hence, any note with a maturity exceeding 9 Months seems to come squarely within definition. (d) Purpose was to separate short term loans by commercial banks for consumable goods versus loans by investment banks 2) However, many extensions of credit do not have attributes of an investment and have not been deemed securities. (used context clause 3) Courts had applied a number of tests to determine. c) Reves v. Ernst & Young: Circumstances where note falls under Securities law Family resemblance test 1) Do not Apply howey to notes: (howey is for investment Ks) 2) First there is a rebuttable presumption that every note is a security unless it bears a strong family resemblance to a category of instruments that are not securities. 3) Notes which are not securities include: (a) Notes used in consumer lending (b) Notes secured by a mortgage on home (c) Short term note secured by lien on a small business (d) Short term note secured by an assignment of accounts receivable (e) Note evidencing a character loan to a bank customer (f) Note formalizing an open account debt incurred in ordinary course of business (g) Notes of loans by commercial banks for currents operations. 4) 4 factors to consider: (a) Motivation that would prompt seller and buyer to enter into it (i) if the issuer of the note uses the proceeds for general business purposes, and buyer is interested primarily in profits it is more likely a security. (ii) If the issuer gives the note to buy consumer goods, minor asset or for some commercial or consumer purpose, it is more likely not a security (Cite United v. Forman). (b) Consider Plan of distribution to determine if it is instrument where there is trading for speculation (i) If notes are widely offered and traded, it is more likely a security (even if just sold to broad segment of public) (ii) If the note is given in a face-to-face negotiation to a limited group of sophisticated investors, it is more likely not a security. (c) Reasonable expectations of investing public (i) If investors view the type of notes to be investments, it is more likely a security. (d) Other facts reduce risk (i) If the note is not collateralized and not subject to other types of securities regulation, it is more likely a security. (ii) If the note is secured or otherwise regulated it is more likely not a security (cite Marine Bank which was subject to banking regulations) 5) Holding: note is a security; (1) sold in effort to raise capital for business ops and purchasers wanted profits (there was high interest rate); (2) sold to broad segment of public; (3) advertisement characterized notes as investments so people expected them to be; (4) no risk reducing factor, since uncollateralized and uninsured and instant liquidity doesnt matter; (5) even though payable on demand does not fall w/in less than 9 month exception. 6) See page 22 of notes, Problem 3-10 (201) for examples of notes

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Bank instruments as securities a) Marine Bank v. Weaver (159, 1982) - CD not a security (case is right after Howey) 1) Facts: P, weaver, pledged a Certificate of Deposit (CD) as collateral to guarantee a bank loan. When bank reneged on its promise to deliver the loan proceeds, P claimed defrauded under 10b-5. 2) Holding: bank CD is not a security. Although has attributes of a long-term debt instrument, the court said: (a) Limited risk: that bank CD are federally insured and subject to comprehensive banking regulation. The alternative regulatory scheme (banking laws) renders unnecessary securities regulations. (b) Private vs. Public: the agreement involved no prospectus and was not designed to be publicly traded. 3) Haft criticizes this opinion saying that even if this is a private transaction it is still subject to the antifraud provisions General factors courts have considered a) Manner and offering and sale 1) Offering to the general public more likely a security while a two-party directly negotiated transaction is less

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(h) SEC Offering Reform Rules July 19th 2005 (i) General: SEC felt that existing gun jumping rules were overly restrictive and were inconsistent with the capital formation process.42 (ii) Amount of flexibility created by rules is contingent on characteristics of issuer (1) Well known seasoned issuer: S-3 + current in reports + $700 mil of float or $1 bil non-convert (2) Seasoned: issuer eligible for shelf (3) Unseasoned: reporting co not eligible for shelf (4) Non-reporting issuer duh (5) Ineligible issuers: RULES DO NOT APPLY a. Reporting issuers that are not up to date b. Blank check, penny stock, or shell companies in last three years c. Limited partnerships offering securities other than firm commitment d. Registered investment companies e. Certain Issuers subject to bankruptcy in last three years f. Issuers convicted of felony or subject to decree for sec fraud (iii) General relaxation on Gun Jumping (See handout) (1) Rule 135: did not change, can still publicize specified limited info about a proposes offer (2) Rule 163: WKSIs can engage at any time on oral or written communications (completely exempt can make oral or written offers to sell at any time) a. They can do this through a free writing prospectus (but may need to file with SEC) b. Haft: this is all embracing of the efficient market theory need not gag order them because so big and so covered we want them to release info all the time. c. Haft: Still protected by antifraud!!!! (3) Rule 168: Reporting cos can at any time publish regularly released factual business43 info and forward-looking info44 a. The issuer must have previously released such info and the current release must be consistent with past releases (4) Rule 169: Non reporting issuers can only release factual business info not intended for investors. (5) Rule 163A: All companies may talk for the period up to 30 days before filing a. Cannot reference the offering and b. Issuer (other than WKSI) must take reasonable steps to prevent further distribution of the communication during the 30 day period prior to RS. c) Other Activities permitted during the waiting period 1) Prelim negotiations (a) 2(a)(3) exempts from the definition of offer preliminary negotiations or agreements between the issuer and the underwriters, or among underwriters, that will be in privity with the issuer.. (b) Who is excluded depends on who is an underwriter defined in 2(a)(11) so as to exclude those whose interest is limited to a commission from the underwriter not in excess of the usual and customary distributors. (i) The members excluded by this language are members of the selling group who absorb none of the offerings risk. SO UWs cannot make offers to selling group yet See problem 4-6 2) Rule 135: permits the issuer (not the underwriter) to announce its intention to make a public offering by stating: (a) the amount and type of security to be offered, and (b) the manner and purpose of the offering (see above) 3) Broker dealer activities: Investment letters (170) note: for exemptions issuer must be reporting co HAFT SAYS NOT IMPORTANT FOR THIS COURSE, JUST KNOW THEY ARE THERE. 4) Generally: These address the 5 issues for investment professionals who regularly circulate investment recommendations to their clients. 5) Rule 137: (Nonparticipant recommendations). Requirements: billy- dont want to destroy market efficiency on outstanding shares by limiting available info on issuer via 5) factual info: business info, advertisements, announcements of dividend, 34 Act reports 44 forward looking: projections, plans and objectives for future ops, future performance (including MD&A), assumptions
42 43

(iv) Press and public usually excluded. (v) Attorneys often file meaningful cautionary language with the SEC to get protection of safe harbor for forward looking info under PSLRA. 2) Electronic Communications: Are road shows oral communications or written offers that need meet 10 (a) As discusses above 2(a)(10) defines prospectus as written communications including written, printed, broadcast, and graphic communications but not live real time communications to live audience regardless of the medium (these are oral communications) (b) A road show can either be a oral communication or written and thus a prospectus (but a free writing prospectus that need not be filed*) (i) Oral and not prospectus that needs to be filed: Must be live communication to live audience (1) Graphic info presented at such a roadshow, need not be filed (2) Written info distributed needs to be filed as free writing prospectus (3) The oral communications are still subject to ANTIFRAUD PROVISIONS of 12(a)(2) and 17(a)(2) (ii) Written Communication and thus a free-writing prospectus: Those not live and that are graphically transmitted (1) Need not be filed with SEC unless non-reporting co in which case need not file if road show is readily available without restriction electronically to any potential investor. (c) What about rule in book that if you make road show available to limited investors and password protected it is not a prospectus? (179) (d) Haft Comments on Road Shows (i) SEC has democratized the Road show by treating it as a free-writing prospectus (ii) If you make it available electronically to any single investor, it must be made electronically to the world (iii) This lets the molly goldbergs to hear all the good things about the company above and beyond what is covered in the preliminary prospectus. h) Other Electronic communications and waiting period -- fuzzy lines 1) E-mails - prohibited because = written communication? (a) Problem: email has characteristics of oral and written communication. (b) SEC view: email that are short, and are probably substitutes for telephone conversations are probably oral in nature and are permitted during waiting period, but dissemination of an offering document by e-mail to a broader audience is not cause more like written. 2) Web sites (a) Posting of a prospectus on web site has been considered ok. (b) SEC has said issuer may not hyperlink its prelim prospectus to research reports by other firms cause like mailing additional written materials (and could be considered conditioning)

Remember that those things that are not considered prospectuses still cannot contain misleading statements because they are still subject to antifraud.
i) PROBLEMS PAGE 179 1) Problem 4-15: press release announcing that is has filed a RS for IPO of 2 million shares and other info. Rule 134 applies only during waiting period. Much more liberal than Rule 135 (prefiling rule). The press release is a violation of 5 because it is a writing and is not within 10 and it is not within Rule 134. You cant put in any more than Rule 134 allows SEE RULE. Information about earnings per share in last two years is not allowed. (a) This could be a free writing prospectus and hyperlink to the preliminary 2) Problem 4-13: broker orally offer to a customer to purchase and sends her a preliminary prospectus. Oral offer is ok, and under Rule 430 preliminary/red herring prospectus is ok to send to customer, this meets 5(b)(1)s requirement that need to send 10 prospectus. 3) Problem 4-14: broker sends a form to a customer and attaches a business card that says this is a good buy. This is violation (saying it is a good buy) because it doesnt meet requirements of 10. But the sending of the form to the customer is not a violation because it is allowed under Rule 134(d) (can send communication to investor asking them to express interest). But there are requirements for the form needs to include statement that cannot buy until RS is effective & Needs to be proceeded or accompanied by a prospectus. 4) Problem 4-15: She sends note back to broker with money put me down for 100 shares. This is probably a

(b) Large number of units in small denominations (public) 3) Size of the offering: (a) Small = Private (initially 4(2) meant for small offerings 4) Manner of Offering: (a) Effectuated through negotiations are better (b) Absolutely no general advertising or solicitation is permitted 5) Availability of information - considered the key factor in applying exemption because 33 act is based on disclosure in registration process as best protection for investors. (a) information access or disclosure (Doran) (i) By actually disclosing info to offeror (ii) By offeree having access to info based on relationship with issuer (insider, family, bargaining power) 6) Nature of offerees - financial sophistication of the investor and ability to bear the economic risk of the investment (remember needs to be sophisticated (maybe) and have access to info). 5. COURTS APPLYING 4(2) a) Courts have interpreted 4(2) not limit the dollar size of a private offering or number of investors b) Instead courts have formulated a sliding scale of investor sophistication and access to info. c) SEC v. Ralston Purina Co: Focus should be on the need of the offerees for protections of he act 1) Ralston Purina has policy of selling common stock to key employees - without registration. Hundreds of employees in variety of positions and purchased unregistered stock. SEC sued to require reg. 2) Holding: 4(2) exemption applies when offerees and investors, regardless of their number, are able to fend for themselves, such as executive personnel with access to same kind of information that would be available in RS. In this case, court held stock purchasers lacked this access and info and reg was required (absent such access employees just as much members of the investing public as their neighbors). 3) This approach is consistent with the purpose of the act which is to protect investors by promoting full and fair disclosure of info necessary to informed investment decisions 4) Billy this makes clear that an offer need not be open to whole world for it to be public

d) Requisite Offeree Qualification: Sophistication and Access to information 1) Ralston emphasized that Access to information was the critical inquiry but also commented that an offering is not public when limited to those who could fend for themselves these 5th circuit cases address the issues underlying private placement exemptions 2) Hill York Corp. v. American Intl Franchises, Inc. (1971) Sophistication no substitute for information (a) Facts: purchasers were sophisticated businessmen and attorneys who bought stock in fast food corp and only received misleading brochures. Court said that exemption requires investors (no matter how sophisticated) need access to info (b) Holding: court denied 4(2). The offerees neither knew the issuer or its business, and unlike insiders of a corp, they lacked a privileged relationship with issuer. Lacking such access to info they were in need of protections of registration regardless of their sophistication (soph no sub for info) 3) SEC v. Continental Tobacco Co. (1972) Information but no sophistication (a) Facts: Ps received written prospectus and financial stmts and signed investment letters. (b) Holding: court denied exemption because investors lacked sophistication. Purchasers did not have opportunity to inspect corp records. Court suggested investors must have personal contacts with corporate officers. Must show that all offerees received info on co. (c) Note: considered a bombshell seemingly requiring offerees to have insider status. But Doran explicitly said insider status not required. 4) SEC v. Woolf SD Cohn & Co (1976) Sophistication but not insider (a) Court clarified that the 4(2) exemption does not depend on insider status sophisticated outsider can be qualified. 5) Doran v. Petroleum Management Corp (1977) Sophistication and Disclosure or Access to info (a) Court held that investors must receive or have access to information comparable to that found in RS (b) A finding of sophistication does not end the inquiry because it does not eliminate the need for information (c) Availability of info means disclosure or access (i) If disclosure (equivalent to what is in RS and maybe more) is exercised, the absence of a relationship between the issuer and offeree would not preclude a private offering (ii) If access to info is the measure, the relationship between the issuer and offeree becomes critical to see if he could realistically have been expected to take advantage and he also need to be sophisticated enough to ask the right questions.

of fed sec violations; issuers whose execs had been subject to sanctions; etc. See Rule 262. 2) Not available to reporting company, investment companies etc. d) Issuer may test the waters prior to filing (allows for general solicitation; THIS IS HUGE!!!): Makes it useful for small, national offerings to investors over the internet (322-23) (Can also alter course after testing and testing will not be seen as illegal solicitation). 1) Written document to determine interest or oral communication allowed 2) Written offers must be made after offering statement is filed 3) Offers cannot be accepted until offering statement is qualified. e) Preclude integration of Reg A offering with either (See 321) 1) Any prior offering or 2) Later offerings that are registered, made in compliance with Rule 701 or Reg S or made more than 6 months after the Reg A offering Substantial compliance defense available

f) 3.

Reg D versus Reg A a) Reg A results in the issuance of unrestricted securities as opposed to Reg D, they can be resold imediately b) Reg A may be conducted as a public offering without restrictions on manner of offering (can be general solicitation) or eligibility of offerees (doesnt matter). c) Reg D has no ceiling (at least under 506) on amount of securities that can be issued. 1) Reg D may be used by both small issuers and giant public corporations. 2) Reg A is mainly attractive to small business issuer because of $5 mill ceiling. d) Reg A also allows Secondary offerings by existing security holders up to $1.5 million while Reg D is for issuers. e) Requires mini-registration vs. Reg D which requires no filings with the SEC (but need not print offering because can file and make offering on internet

5.

PORTAL a) At same time adopted 144A, SEC approved the creation by NASD of an electronic market to trade Rule 144A securities. Haft: a) This is used a lot by WKSIs. b) Allows companies to sell to UWs w/out registration (i.e. under Reg D) an unlimited dollar amount of securities for immediate resale to qualified institutional buyers who then are able to resell at any time in an active trading market within closed loop of QIBs c) Securities are restricted but can still resell within this closed loop d) makes these securities very liquid (unregistered to instantaneous) e) Good thing: if co is doing 144A offering of securities in a a US reporting co, after 1 year QIBs can sell outside the loop and into open market? f) This along with reg S are principle offerings for outside US. g) many, if not most, 144A offerings are coupled with Reg S offerings (for the foreign part)

6.

B. REGULATION S OFFERS AND SALES MADE OUTSIDE THE U.S. W/O REGISTRATION
1. Basic principle a) Creates safe harbors for offshore distributions and resales of unregistered securities of US and foreign issuers b) Registration requirements of the 33 Act do not apply to offers and sales made outside the United States made either by foreign or domestic companies. Purpose is to allow US companies to tap foreign markets. c) Regulations created to ensure that securities distributed and offered outside the US do not end up with US investors. Statutory structure a) Rule 901: sets out general stmt of the reg. 1) Explains that the 5 terms offer offer to sell sell do not include offers and sales occurring outside the US. b) Rule 902: definitions c) Rule 903 - Safe harbor for issuers and distributors 1) Compliance with the regulation means the transaction will be deemed to occur outside the US. 2) Divides issuers into three categories according to the relative likelihood that securities of that category of issuer will enter American trading markts d) Rule 904 - Safe harbor for resales by others General conditions a) Offshore transaction: the offer or sale must be made in an offshore transaction. 1) Rule 902 defines as a transaction in which the buyer is outside the US at the time the buy order is placed. 2) For the purpose of 903 (issuer safe harbor), the sale is made in, on or through a physical trading floor of an established foreign securities exchange or 3) For the purposes of 904 (resale safe harbor), the execution of the transaction and delivery of the securities takes place outside the US and transactions is not pre-arranged with a buyer in the US. b) No direct selling efforts in the US: 1) Directed selling efforts are activities that are intended to, or could reasonably be expected to, result in conditioning the market in the US for the securities offered. Rule 903 Issuers and distributors safe harbor (see page 220-21) a) General 1) The safe harbor for issuers is divided into three categories, depending on: (a) the nature of the securities offered, (b) the issuers status as a 34 Act reporting company, and (c) the degree of the US market interest in the securities offered. 2) Focuses on the relative likelihood of securities entering the US markets. b) Category 1 - foreign issuers without substantial US market interest. 903(b)(1) 1) If there is no substantial US market interest in the securities or foreign issuer that direct their offering to residents of a single country, the foreign issuer need comply only with the two general conditions.

2.

3.

4.

4.

So who is an underwriter under language? a) Ordinary underwriter who for a commission promises to see that an issue is sold b) Underwriter that purchases issue outright and then sells. c) Underwriters of underwriter: ie. in underwriting syndicate d) Participants in the underwriting purchase e) See also Control person rules THREE IMPORANT CATEGORIES OF UWS UNDER 4(1) a) Agent for issuer: Offers or Sales for issuer: Those who offer or sell for an issuer in connection with dist 1) I.e. investment banker in best efforts offering, who for a fee entices investors who then purchase directly from the issuer 2) SEC v. Chinese Consolidated Benevolent Society (a) not for profit group of Chinese-Americans sought to encourage the purchase of China bonds through mass meetings, newspaper ads, and person appeals without specific authorization by govt. Committee acted on requests by purchasers, had no contractual relationship with the Chinese government and never charged purchaser or any corp (b) Holding: these activities by the association constituted transactions by an underwriter and, because the bonds were not registered, illegal under 5 of Securities Act. Purchasers deserved protection and info of registration, whether or not issuer authorized or compensated the selling activities. 2(a)(11) covers these continual solicitations which lead to distribution of unregistered securities. Even if not UW this was an issuer transaction and Society participated. (c) Rule: to be considered an agent of the issuer, it is not necessary that the agent be compensated or that the issuer knows about the agent or authorizes the solicitation (d) Haft, granted not exempted how could they violate 5 of did not offer to sell (they did) (i) 2(a)(3) definition of offer includes solicitation of an offer to buy 3) Participating in offer or sale for issuer in connection with distribution (a) Can include directors officers and promoters who have actively promoted an unregistered security. (b) UW retained to do due diligence on offering of another I-Banks securities was held to fall within the participates language of 2(a)(11) b/c it is broad enough to encompass all persons who engage in steps necessary to the dist of securities b) PURCHASER FROM ISSUER WITH A VIEW TO THE DISTRIBUTION: 1) Those who purchase from an issuer with a view to the distribution of securities (a) I.e. investment banker in a firm commitment UW that purchases from an issuer and resells its allotment to retail dealers or directly to investors. (b) A person who purchases securities in a private placement and then resells in a public trading market is an UW if she purchased with a view to resell to public (view to distribution)51 2) Disposition of a security must be for value (i.e. giving unregistered securities to school as endowment makes the school a purchaser). 3) Definition of a with a view to distribution (investment intent): With a view to securitys distribution suggest that a UWs status is assumed by one who acquired an unregistered sec for other than long term investment (a) Holding period: (i) holding period of two years establishes presumption of investment intent (ii) After two years, Molly Goldberg can sell b/c ordinary trading transaction but control persons cannot sell w/out registration b/c of their status offense (iii) U.S. v. Sherwood: (1) presumption in favor of investment if held for more than two years (2) Presumption in favor of distribution if share have been held for less than two years. a. factors of the purchasers circumstances when he purchased the shares and b. a change in circumstances after their purchase must negate any intent to distribute

5.

51

They act as a link in the chain of transactions through which securities move from an issuer to the public.

4) This means a transaction would be outside 144 (a) to privately negotiated transactions not involving a broker (b) where buyers interests were solicited by the broker (c) if sellers adviser negotiated the same and received a substantial fee for her services greater than customary commission (d) Why have this provision? (i) underwriting necessarily requires promotion. Want to make sure dont have this promotional hype, want ordinary trading transactions. e) Notice of intent to sell (Rule 144(h)) 1) Seller who intends to sell more than 500 shares, or any number of shares for an amount greater than $10K must file with SEC an notice. Exemption from requirements for nonaffiliates/noncontrol persons (Rule 144(k)) 1) RESTRICTED SECURITIES and NON CONTROL ONLY!!!!!! 2) Restricted securities may be sold without complying with any of the requirements (Rule 144 (c), (e), (f) and (h)) as long as holder is not an affiliate or hasnt been an affiliate for 3 months prior to the sale and two years have passed since the securities were acquired. 3) (e) is sale limitations; (f) is broker transactions; (h) is notice 4) This is really for venture capitalists so they are not locked into their securities for long time subject to limitations of the rule.

f)

4.

OVERVIEW OF TRANSACTIONS EXEMPTED FROM SECTION 5 BECAUSE DO NOT INVOLVE ISSUER, UW, DEALER a) Holders of restricted securities who wish to sell w/out registration 1) Wait till securities have come to rest (holding period no view to dist???) uncertain 2) Comply with rule 144 safe harbor for secondary distributions 3) Avoid distribution and sell in non-public transaction b) Control persons who wish to sell w/out registrations 1) Claim that isolated sales into pub market are not distributions dangerous 2) Comply with rule 144 3) Avoid using UW by selling in non-public transaction or even by selling directly on their own (cf. Wolson) Note: Can also have issuer register shares through piggybacking or demand rights (see E&E 239)

SEE ALSO PROBLEMS 6-11 6-23 page 367 Securities week 8 SEE problem C sprats outline page 64

D.
1.

RULE 145: RECLASSIFICATIONS OF SECURITIES, M&A OF ASSETS

Generally a) Business combinations and recaps trigger 5 concerns whenever they involve the issuance of securities b) Former rule 133 provided that securities issued pursuant to a combination structured as mergers or purchase of assets were beyond 5 b/c the submission to acquisition by SH vote was deemed not to involve a sale of acquiring corps shares (haft says was idiot rule because was offer of acquiring cos stock and SHs needed info) c) Today Rule 145 extended reg reach of 5 when securities are issued in connection with business combinations (mergers, consolidations, reclassifications, and asset acquisitions) unless there is an exemption 1) Now in merger or acquisition of assets, acquiring corp that is offering securities to acquired corp SHs is required to register absent exemption 2) 3(a)(9) only applies to SHs of issuer so 3(a)(10) may apply. 3) Unique aspect 145 affiliates: is it treats control persons of in the acquired or recapitalized corp UWs who have to follow resale restrictions in the rule. (145(c)) Provisions: a) Rule 145 provides that securities issued in certain corporate reorganizations, previously exempted from 5 by rule 133, must be registered and that transfer limitations must be placed on the stock received by certain SH of acquired or recapitalized corp. b) Transactions covered 1) General: Makes it clear that proposals for certain business transactions that require the approval of SH of the selling company are offers under the 33 Act and that consummation of such transfers is a sale under that Act. 2) Reclassification: any reclassification of securities, other than a stock split, reverse stock split, or change in par value, that involves the substitution or exchange of one security for another is subject to Rule 145. 3) Mergers or consolidations: Rule 145 applies to statutory merger, consolidation, or similar acquisitions of one corp by another, in which shares held by As security holders will become exchanged for shares of B. (a) Unless sole purpose of transaction is change in domicile. 4) Transfer of Assets: A transfer of assets by one corp to another is subject to Rule 145 if: (a) Plan calls for dissolution of target corp (b) Plan calls for pro rata distribution of the exchanged securities (c) The BOD of corp adopts resolutions relative to dissolution or distribution within one year after the taking of such vote or consent (d) Subsequent dissolution or distribution is part of the pre-existing plan for distribution c) Registration under rule 145 1) SEC has provided a form for registration of securities issued in business combination transactions. (a) Form of registration: Form S-4 is the proper registration form to be used in rule 145 transactions. Requires detailed info about the proposed transaction. Also requires info about the acquiring company and acquired. Level of detail depends on whether each company would be a S-3, 2, or 1 company. (i) Proxy info: Statutory merger and acquisition of assets requires the shareholders of a target company to vote which means a proxy statement that contains full disclosure is needed. The good news is that Form S-4 includes proxy disclosure. Generally, sh of acquired corp receive a combined proxy stmt/ prospectus on Form S-4. (b) Delivery of prospectus: a prospectus must be given to all those who are security holders of record in the acquired company in a rule 145 transaction and who are entitled to vote on the proposed transaction. 2) Communications not subject to prospectus requirement: certain written communications made to Sh of the selling company are not deemed to be a prospectus or offer to sell. These communications are listed in Rule 145(b). They typically include notice of proposed action or notice of a meeting of sh and Rule 135 stuff.

2.

d) UWs in Rule 145 transaction: Rule 145 affiliates persons deemed to be engaged in distribution (145(c)) 1) Control persons of the acquired corp prior to the transaction covered by Rule 145 are deemed to be UWs when publicly offer securities received from acquiring corp and as such are restricted in subsequent transfers of the securities they receive in a Rule 145 transaction (a) The UW status applies even though after the acquisition the holder is not a control person of the acquired or recap corp. (b) Why? Prevent abuses that may occur when controlling person of target co tries to resell the securities of the acquiring corp. (SEC saw this as similar to spinoff)

(b) Did not need to disclose the problems with strategic alliance because statements suggested hope that would find partners so not definitive projections that need later correcting (c) Had duty to update when company began to seriously consider alternative method of financing that was would place the alliance under different light 3) Rule: a duty to disclose (update) whenever secret information renders prior public statements materially misleading, not merely when the information completely negates the public statements b) Gallagher v. Abott Laboratories: No Duty to update continuously 1) Abott received letter from FDA insisting on penalties but Abott did not disclose to public until it was in compliance and settling. Ps said that Abott had absolute duty to disclose all information material to stock price as soon as it became available. Ps point to Item 303 of Reg SK, which demands that management must disclose risks or trends, and though 10K did say Abott had been subject of regulation, it had duty to update/correct the 10K when later got the letter. 2) Held: No general duty to update continuously (a) 13 requires issuer to file annual and periodic reports not continuing disclosure (need not update form 10K or disclose regulatory issues in 10Q) (b) There is only a duty to correct statements that were incorrect when made and nothing in report was so requiring a running narrative would be updating not correction (c) See Also example on no duty to correct projections -- not rendered false when world turns otherwise c) Duty to UPDATE: Cases indicate Split: statement is true and correct when issued and subsequent events make it materially misleading or false. 1) Mere possession of non-public information by an issuer by itself does not give rise to a duty to update 2) Some statements that become inaccurate b/c of subsequent events courts require update (Time) 3) Possible duty to update if statement remains alive (a) Some courts hold that even when statement is true when released, it assumes duty to revise or update if the forward looking statement is still alive in marketplace and has became inaccurate still being relied upon (b) Some limit to statements of important company policy (i) Duty to update alternative method financing (Time Warner) (ii) Company stated its policy to maintain stable debt to equity ration came under duty to disclose negotiations of merger that would have added significant new debt (Weiner v. Quaker Oats) 4) Times when CLEARLY have to update: Offering of securities (a) Rule 10b-5 at a minimum does impose duty to keep information in prospectus or private offering Memo fresh during offering of securities 5) Haft on Duty to update (a) Duty to update is beyond materiality b/c would have to update everything (b) Need very Stringent Bright line Rule (highly material special significance) (c) You can only stay silent 90 days due to quarterly filing but 8K makes it 30 days (i) Form 8K needs to be filed monthly if there is a triggering event and SEC expanded the list

d) Duty To CORRECT 1) Duty to correct statements materially57 false when issued and company discovers falsity subsequent 2) False statements by 3rd parties: (a) No duty to correct false statements made by 3rd parties unless company is entangled with the 3rd statement in which event you need to correct or are liable (i) Company reviews research reports by analysts and revises parts of it it adopts it (ii) Company distributes false reports (iii) Hyperlink to website (even if put blanket warning about statements by third parties) (b) In a way this is aiding and abetting, but courts hold liable. e) Duty to disclose may exist if have some pre-existing fiduciary relationship 1) Normally silence is not actionable under rule 10b-5 2) Bank as transfer agent for SHs corp had a relationship of trust that compelled it to speak fully about selling options (Affiliated Ute) 3) A duty to speak arises when a closely held corp deals with SH employees (Jordan v. Duff) May also have affirmative disclosure obligations under listing standards 1) NYSE states that a listed co is expected to release quickly to public any news which might affect market for sec These laws have not teeth

f)

57

When addressing duty to update or correct IT MUST BE MATERIAL DONT FORGET THIS ON TEST

d) United States v. OHagan 1) OHagan was a partner in a law firm. Grand Met retained the firm as counsel regarding a potential tender offer of Pillsbury (both parties took precautions for confidentiality). Ohagan did not work on the deal. OHagan began buying call options for Pillsbury (not the clients stock but the bidders so not temp insider). He was charged with violations of 10b, & violation for fraudulent trading in connection with a tender offer of 14(e). 2) Deceptive device: (a) missappropriator deceives the source of the info by feigning loyalty while secretly converting to personal use (disclosure makes for no deceptive device) 3) in connection with sale of security: (a) fraud consummate not when acquires, but when without disclosure to his source, he uses the information to purchase or sell (deception through non disclosure is central to this theory) (b) this is so even though the person the missappropriator defrauds is not the party with whom the miss trades but, but is instead the source of the info he gains his unfair advantage through deception (c) 10b-5 requires deception in connection with not deception of an identified purchaser or seller 4) Rules From Ohagan (a) A person who trades in securities for personal profit, using confidential information misappropriated in breach of fiduciary duty to the source of the information is guilty of violating 10(b) and Rule 10b-5. e) Rule 10b5-2 sets out 3 nonexclusive situations in which a person has a duty of trust for miss 1) Agrees to maintain information in confidence 2) History or pattern or practice of sharing confidences 3) When receives or obtains material, non pub info from spouse, parents, children and siblings (unless show that under this relationship no duty of trust or confidence existed) The Role of disclosure: Forecloses liability b/c only secretive breaches are violations 1) If Fiduciary discloses to the source of the information that he plans on trading on the information, there is no deceptive device and thus no 10b liability 2) This means the source of the information can authorize it or can just tell that they are trading 3) May be liable under state law 4) Policy Concerns: why look to relationship with employer and employee (a) Limits to secretive breaches Not sensible given basic purposes of the insider trading prohibition because definitions of wrongfulness rest on purely private considerations that have nothing to do with the harm to the investor but to the party from which the info was obtained (b) This is just criminalizing private info

f)

8.

RULE 14E-3 a) SECs response to Chirarellamakes conduct in Chiarella a violation of the Williams Act b/c most prevalent and profitable form of insider trading. 1) Once substantial step toward a tender offer made, 2) It is a fraudulent deceptive or manipulative act for any person who is in possession of material info relating to the tender offer to purchase or sell any of the targets securities if the person knows or has reason to know that the information is: (a) Is nonpublic and (b) was acquired from the bidder, the target, or any person associated with either one of these b) anti-tipping provision 1) bars the communication of material nonpublic information concerning a tender offer to persons where it is reasonably foreseeable that such communication is likely to result in unlawful trading. c) No reference to breach of fiduciary duty: 1) OHagan held that SEC did not exceed its rulemaking authority by adopting rule 14e-3(a), which proscribes trading on undisclosed information in the tender offer setting, even in the absence of a duty to disclose d) Substantial step: having meetings with target, retained counsel etc.
TIPPERS AND TIPPEE LIABILITY

9.

a)

Dirks v. Sec: tippee liability 1) Secrist, tipped Dirks that the corporations overstated its assets. While investigating, Dirks discussed the info he obtained with a number of clients and investors, some of whom sold their holdings. SEC said he aided and abetted violation of Rule 10b-5. Held: In the absence of a breach by tippers (who received no monetary or personal gain) there was no derivative breach by dirks: 2) Dissent: gain to tipper is irrelevant, look to consequence on the shareholder. 3) Rules: (a) No general duty to disclose before trading on material nonpublic information (Mere possession not enough

2.

THE SHINGLE THEORY AND FIDUCIARY OBLIGATIONS a) When Broker actually lies to customer about a particular fact, fraudulently inducing a purchase or sale in order to generate commission, the applicability of 10b-5 is clear. b) Not so clear when there is not an obvious form of deceit, just a breach of trust to customer since antirfraud provisions cover only misrepresentations (not unfair conduct) made intentionally (not negligently) c) Fictional Judicial interpretation filled in the gap to find fiduciary duties between BDs and custoemrs d) Two lines of authority 1) Some courts apply traditional fiduciary principles so that breach of duty acts as fraud on the customer though much confusion over this 2) All lower fed courts have accepted the Shingle Theory to find a fraud that permits SEC to impose sanctions and gives a rise to PRA under 10b-5 e) SPECIFIC RULE 10B-5 THEORY: THE SHINGLE THEORY 1) Generally (a) Under theory courts have assumed that a broker dealer who engages in a securities business hangs out a shingle impliedly representing that he will deal fairly, honestly, and competently with his customers, and customers place their confidence in this implied representation. (b) theory creates a duty of fear dealing, and any breach of that duty can easily be deemed fraudulent since it involves an implied representation (c) Implied representation to deal fairly is different from disclosure not like 33 Act and need more than disclosure although disclosure may cure some violations. See 17.4 (d) Scienter: Rule 10b-5 requires scienter which is evil intent/recklessness and Sct seems to think disclosure is enough so we will see when they rule on Shingle theory we have seen them overrule longstanding rules (e) Reliance: Relationship itself creates reliance but courts reluctant when sophisticated (Banca) 2) Specific Duties which are under Rubric of Shingle Theory, which is under Rule 10b-5 (a) KNOW THY SECURITY: DUTY TO INVESTIGATE OR BECOMES FRAUD: NO PRA UNDER THIS DUTY (i) Generally (1) Broker dealers must investigate the issuer and the terms, risks, and the nature of the securities they recommend. (2) Broker dealers may not recommend securities without having an adequate basis for their recs. (3) Failure to investigate and subsequent recommendation becomes a fraud (ii) Hanley v. SEC : (1) BD recommended security of co that was insolvent. Made recommendations after friend mentioned it to him + gave him confidential report about license acquisition + confirmed by co president + really strong affirmative represenations like this is a winner (2) Court used the duties outlined under the shingle theory to hold the broker dealer liable for fraud. Held that by his recommendation, he implied that he conducted a reasonable investigation when he did not. (3) Duty to Investigate a. cannot recommend a security unless there is an adequate and reasonable basis for such recommendation. b. He must disclose facts which he knows and those which are reasonably ascertainable. By his recommendation, he implies that a reasonable investigation has been made. (4) Other notes a. Notes that private actions probably could not be brought under the shingle theory b. Stocks were OTC so info not readily available so higher duty possibly c. See problem 7.15 (iii) Nature of the investigation: (1) Not full due diligence but Cannot rely blindly on statements by managers (b) FORSAKE THE UNSUITABLE & KNOW THY CUSTOMER: PRA AVAILABLE (i) Generally (1) As part of knowing their customer and the securities they recommend broker dealers must have reasonable grounds for believing a particular securities transaction is suitable for a particular customer given his financial situation, trading purpose, and needs. a. EX: high risk options trading is unsuitable for retired school teacher looking for safe investment (2) In the end case may depend on how extreme the facts are, including ability to asses risk

DUTIES OF SECURITIES LAWYERS

1. GENERALLY: a. SEC has often taken the position that Sec lawyers have a special responsibility to the public and that a lawyer who knowingly assists a client in a securities fraud becomes subject to civil and criminal aiding and abetting liability Two leading cases are SEC v. National Student Marketing and In re Carter Johnson SEC V. NATIONAL STUDENT MARKETING CORP a. Several lawyers were found guilt of aiding and abetting violations of 10(b), Rule 10b-5 and 17(a) who allowed a merger to go forward after the accountants had told the lawyers that the proxy statement for the merger contained misleading financial information (law firm was vicariously liable) b. Elements of Aiding and Abetting: i. There needs to be a primary violation ii. Ds need to be generally aware of the fraudulent activity iii. Ds need to provide knowing substantial assistance to the violation: c. Held: Silence constituted substantial assistance so they aided and abetted violation. i. Courts willing to consider inaction as a form of substantial assistance when the accused aider and abettor had a duty to disclose ii. Court required them to take steps to ensure that the info would be disclosed to the SHs At the very least, they were required to speak out at the closing concerning the obvious materiality of the info and require that merger not be closed until the adjustments were disclosed and SHs were re-solicited. iii. Silence was not only a breach of this duty to speak, but also lent legitimacy to the closing d. In Sum: Counsel had a duty to the interstate SHs to delay the closing of the merger pending disclosure and resolicitation with corrected financials, and that breach of duty constituted a violation of the antifraud provisions through aiding and abetting the merger transaction. e. SEC Wanted court to go further i. SEC said they had duty to squeal to SEC Court said nothing on this ii. SEC said they had duty to inform SHs Court did not require this iii. SEC said lawyers for both companies had duty to withdraw their opinions Court did not hold on this basis and said opinion did not substantially assist since both sides knew of the problems iv. No duty to undo merger after it was closed beyond scope of sec laws v. SEC did not levy highest penalty which is permanent disbarment

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IN RE CARTER AND JOHNSONS, SEC THIS WAS COMMISSIONS APPROACH BEFORE 205 a. Facts: two partners of law firm assisted a financially strapped client to negotiate a loan agreement. Lawyers failed to object when client gave its sh overstated projections, though advised to disclose. b. SEC said: faulted the lawyers for not ensuring that their disclosure advice was not followed and for failing to investigate troubling information. The SEC concluded that a lawyer who is aware that her client is engaged in the substantial and continuing failure to meet disclosure requirements violates professional standards if she does not take prompt steps to end the clients non-compliance. c. Rule: An attorney, faced with illegal nondisclosure by a client, abets the nondisclosure if he does not act to stop it. For such aiding and abetting to occur there must be intent on the part of the attorney to intend to aid the violation through action or inaction in conscious disregard to an attorneys ethical obligations with respect to disclosure. d. According to SEC, if have bad client, must take more steps then just counseling to disclose -- these steps includes: i. Approaching the BOD or other senior mgmt ii. Approaching outside directors iii. Resigning e. Note on resignation i. Court noted premature resignation does not serve the end of effective lawyer-client relationship and that lawyers continued involvement will best lead to corrective action (as long as laywer acts in good faith and is not co-opted. ii. But best result is not possible in every situation and there may be a situation where conduct is so irretrievable that lawyer must resign. iii. Haft: The standard is not negligence, it is recklessness if not, we would have over-disclosure that would result in excessive costs etc --- lawyers are paid well to balance not to be wimps.