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TABLE OF CONTENTS
I. DEFINITIONS .................................................................................................................... 6 SECTION 2. DEFINITIONS ....................................................................................................... 6 RULE 405 ............................................................................................................................... 7 II. SECURITIES TRANSACTIONS............................................................................................. 9 CHAPTER 1. CHAPTER 1.1 INTRODUCTION ......................................................................................... 9 SECURITIES MARKETS AND PARTICIPANTS .................................................. 9
CHAPTER 1.1.1 PRIMARY AND SECONDARY MARKETS ................................................. 9 CHAPTER 1.1.2 FUNCTIONS OF SECURITIES MARKETS .................................................. 9 CHAPTER 1.1.3 PARTICIPANTS ................................................................................... 10 CHAPTER 1.1.4 INTERCONNECTION AMONG FINANCIAL MARKETS .............................. 10 CHAPTER 1.2 III. CHAPTER 1.3 EFFICIENCY OF PUBLIC STOCK MARKETS .................................................. 10 FEDERAL SECURITIES REGULATION ± OVERVIEW ...................................... 12 SECURITIES REGULATION .............................................................................................. 12 CHAPTER 1.3.1 SECURITIES ACT OF 1933 ................................................................... 12 CHAPTER 1.3.2 SECURITIES EXCHANGE ACT OF 1934 ................................................. 12 CHAPTER 1.3.3 SPECIALIZED SECURITIES LAWS ......................................................... 13 CHAPTER 1.3.4 SARBANES-OXLEY ACT OF 2002 ........................................................ 13 CHAPTER 1.3.5 SECURITIES AND EXCHANGE COMMISSION ......................................... 14 CHAPTER 1.4 CHAPTER 1.5 CHAPTER 11. IV. STATES SECURITIES REGULATION ± BLUE SKY LAWS ................................ 15 SEC EXEMPTIVE POWER........................................................................... 15 REGULATION OF SECURITIES INDUSTRY ................................................. 16
CHAPTER 11.1 CAPACITIES OF SECURITIES PROFESSIONALS ............................................. 16 SECURITY ....................................................................................................................... 17 DEFINITION OF A SECURITY .................................................................... 17 IMPLICATIONS OF DEFINITION ................................................................... 17 TESTING FOR A SECURITY ......................................................................... 17 CHAPTER 2.1 CHAPTER 2.2 CHAPTER 2.
CHAPTER 2.2.1 INVESTMENT CONTRACTS (CATCH ALL) ± THE HOWEY TEST .............. 17 CHAPTER 2.2.2 RISK CAPITAL TEST ........................................................................... 17 CHAPTER 2.3 SECURITIES IN VARYING CONTEXTS .......................................................... 18 1
CHAPTER 2.3.1 REAL ESTATE AS SECURITIES ............................................................. 18 CHAPTER 2.3.2 BUSINESS INTERESTS AS SECURITIES .................................................. 18 CHAPTER 2.3.4 NOTES AS SECURITIES ....................................................................... 18 CHAPTER 2.3.6 ³STOCK´ AS A SECURITY ................................................................... 20 V. DISCLOSURE AND MATERIALITY.................................................................................... 21 CHAPTER 3. CHAPTER 3.1 MATERIALITY ......................................................................................... 21 DEFINITION OF MATERIALITY ................................................................... 21
CHAPTER 3.1.1 ³SUBSTANTIAL LIKELIHOOD´ TEST .................................................... 21 CHAPTER 3.1.2 REASONABLE INVESTOR .................................................................... 21 CHAPTER 3.1.3 RELATIONSHIP OF MATERIALITY AND DUTY TO DISCLOSE .................. 21 CHAPTER 3.2 MATERIALITY ± TYPES OF INFORMATION .................................................. 22 CHAPTER 3.2.1 HISTORIC INFORMATION .................................................................... 22 CHAPTER 3.2.2 SPECULATIVE INFORMATION .............................................................. 23 CHAPTER 3.2.3 FORWARD-LOOKING STATEMENTS ..................................................... 23 CHAPTER 3.2.4 INFORMATION ABOUT MANAGEMENT INTEGRITY ............................... 24 CHAPTER 3.2.5 SOCIAL/ENVIRONMENTAL DISCLOSURE.............................................. 25 CHAPTER 3.3 MATERIALITY IN CONTEXT: ³TOTAL MIX´ OF INFORMATION...................... 25 CHAPTER 3.3.1 ³TOTAL MIX´ TEST ........................................................................... 26 CHAPTER 3.3.2 SAFE HARBORS FOR FORWARD-LOOKING STATEMENTS ...................... 27 VI. REGISTRATION OF SECURITIES OFFERINGS ................................................................... 29 CHAPTER 4.1 REGISTRATION OF SECURITIES OFFERINGS ................................................ 29 CHAPTER 4.1.1 TYPES OF PUBLIC OFFERINGS............................................................. 29 CHAPTER 4.1.2 PRICING AND COMMISSION IN A PUBLIC OFFERING ............................. 29 CHAPTER 4.1.3 DOCUMENTATION IN A PUBLIC OFFERING........................................... 30 CHAPTER 4.2 REGISTRATION OF PUBLIC OFFERINGS ....................................................... 31 CHAPTER 4.2.1 SECTION 5 OF THE SECURITIES ACT .................................................... 31 CHAPTER 4.2.2 CONTENTS OF REGISTRATION STATEMENT ......................................... 32 CHAPTER 4.2.3 PREPARATION OF REGISTRATION STATEMENT ................................... 33 CHAPTER 4.2.4 SEC REVIEW OF THE REGISTRATION STATEMENT ............................... 33 SHELF REGISTRATION .................................................................................................. 34 CHAPTER 4.2.5 PURCHASES DURING REGISTRATION .................................................. 35 CHAPTER 4.3 MANAGED DISCLOSURE DURING REGISTRATION ± ³GUN JUMPING´ ........... 36 CHAPTER 4.3.1 PRE-FILING PERIOD............................................................................ 37 2
CHAPTER 4.3.2 WAITING PERIOD (AFTER FILING, BEFORE EFFECTIVENESS) ............... 40 CHAPTER 4.3.3 POST-EFFECTIVE PERIOD.................................................................... 42 VII. REGISTRATION UNDER THE EXCHANGE ACT ................................................................. 44 CHAPTER 8.3 REGULATION OF PUBLIC COMPANIES ........................................................ 44 CHAPTER 8.3.1 REGISTRATION UNDER THE EXCHANGE ACT ....................................... 44 CHAPTER 8.3.2 PERIODIC DISCLOSURE ...................................................................... 45 VIII. EXEMPTIONS FROM SECURITIES ACT REGISTRATION.................................................... 47 CHAPTER 5. CHAPTER 5.1 CHAPTER 5.2 EXEMPTIONS ........................................................................................... 47 EXEMPT SECURITIES (SECTION 3).............................................................. 47 TRANSACTION EXEMPTIONS (SECTION 4) .................................................. 48
CHAPTER 5.2.1 INTRASTATE OFFERINGS .................................................................... 49 CHAPTER 5.2.2 PRIVATE PLACEMENTS....................................................................... 49 CHAPTER 5.2.3 SMALL OFFERINGS ............................................................................ 51 CHAPTER 5.2.4 REGULATION D ................................................................................. 51 IX. SECONDARY DISTRIBUTIONS .......................................................................................... 53 SECONDARY AND OTHER POSTOFFERING DISTRIBUTIONS ...................... 53 DEFINITIONS OF ISSUERS, UNDERWRITERS, AND DEALERS ......................... 53 CHAPTER 7.1 CHAPTER 7.
CHAPTER 7.1.1 AGENT ³FOR ISSUER´ ........................................................................ 54 CHAPTER 7.1.2 PURCHASER FROM ISSUER ³WITH A VIEW´ TO DISTRIBUTE .................. 54 CHAPTER 7.1.3 UNDERWRITER FOR ³CONTROL PERSON´............................................ 55 CHAPTER 7.2 SECTION 4(1): TRANSACTIONS NOT INVOLVING AN ISSUER, UNDERWRITER, OR DEALER ............................................................................................... 55
CHAPTER 7.2.1 RULE 144: SECONDARY DISTRIBUTIONS IN PUBLIC MARKETS ............. 56 CHAPTER 7.2.2 EXEMPTIONS FOR SECONDARY PRIVATE PLACEMENTS........................ 57 SECTION 4(3). TRANSACTIONS BY A DEALER .............................................................. 58 CHAPTER 7.3 CORPORATE REORGANIZATIONS AND RECAPITALIZATIONS ........................ 58 CHAPTER 7.3.1 ISSUER EXCHANGES........................................................................... 58 CHAPTER 7.3.2 FUNDAMENTAL CORPORATE TRANSACTIONS ± RULE 145 ................... 59 CHAPTER 7.3.3 DOWNSTREAM SALES AND SPINOFFS.................................................. 59 CHAPTER 7.3.4 WARRANTS, OPTIONS, AND CONVERSION PRIVILEGES ........................ 59 X. EQUAL ACCESS TO INFORMATION: INSIDER TRADING AND REGULATION FD ............... 60 CHAPTER 10. INSIDER TRADING ................................................................................... 60 CHAPTER 10.1. INTRODUCTION TO INSIDER TRADING ........................................................ 60 3
CHAPTER 10.1.1 CLASSIC INSIDER TRADING .............................................................. 60 CHAPTER 10.1.2 MISAPPROPRIATION OF INFORMATION ± OUTSIDER TRADING ............ 60 CHAPTER 10.1.3 THEORIES FOR REGULATION OF INSIDER TRADING............................ 60 CHAPTER 10.2 RULE 10B-5 AND INSIDER TRADING.......................................................... 61 CHAPTER 10.2.1 DUTY TO ³ABSTAIN OR DISCLOSE´ .................................................. 61 CHAPTER 10.2.2 INSIDER TRADING RULES ................................................................. 64 CHAPTER 10.2.3 OUTSIDER TRADING ± MISAPPROPRIATION LIABILITY....................... 65 CHAPTER 10.2.4 REMEDIES FOR INSIDER TRADING..................................................... 66 CHAPTER 10.2.5 REGULATION FD (FAIR DISCLOSURE) AND SELECTIVE DISCLOSURE.. 67 XI. LIABILITY UNDER FEDERAL SECURITIES LAWS ............................................................. 69 CHAPTER 6.1 COMMON LAW OF MISREPRESENTATION ................................................... 69 CHAPTER 6.1.1 COMMON LAW DECEIT ...................................................................... 69 CHAPTER 6.1.2 EQUITABLE RESCISSION ..................................................................... 69 CHAPTER 9.5 COMPARISON TO OTHER SECURITIES FRAUD REMEDIES ............................. 70 CHAPTER 9.5.1 EXPRESS FEDERAL REMEDIES FOR SECURITIES FRAUD ....................... 70 CHAPTER 9.5.2 STATE LAW REMEDIES ...................................................................... 75 CHAPTER 9.5.4 ARBITRATION AND PRIVATE ORDERING ............................................. 76 THE DUE DILIGENCE DEFENSE .......................................................................................... 77 RULE 176 REASONABLE INVESTIGATION ................................................................... 78 ESCOTT V. BARCHRIS CONSTRUCTION CORP. ............................................................... 78 IN RE WORLDCOM, INC. SECURITIES REGULATION ....................................................... 80 CHAPTER 12. PUBLIC ENFORCEMENT ........................................................................... 82 CHAPTER 12.1 SEC INVESTIGATIONS .............................................................................. 82 CHAPTER 12.1.1 INVESTIGATIONS: FORMAL AND INFORMAL ...................................... 82 CHAPTER 12.1.2 INVESTIGATIVE POWERS .................................................................. 83 CHAPTER 12.2 ADMINISTRATIVE ENFORCEMENT ............................................................. 83 CHAPTER 12.2.1 SEC ADMINISTRATIVE ENFORCEMENT POWERS ............................... 83 CHAPTER 12.2.2 DISCIPLINARY POWERS .................................................................... 84 CHAPTER 12.3.3 EFFECT OF INJUNCTION .................................................................... 84 CHAPTER 12.3.4 MODIFICATION OR DISSOLUTION OF SEC INJUNCTIONS .................... 84 CHAPTER 12.3.5 STATUE OF LIMITATIONS ................................................................. 84 CHAPTER 12.5 CRIMINAL ENFORCEMENT ........................................................................ 84 CHAPTER 12.5.1 USE OF CRIMINAL LAW IN SECURITIES ENFORCEMENT ..................... 84 4
................................. 84 CHAPTER 12. 84 CHAPTER 12.5 SENTENCING OF INDIVIDUAL AND CORPORATE OFFENDERS ...CHAPTER 12.....5......5...............3 SECURITIES ACTIVITIES CREATING CRIMINAL LIABILITY...2 CRIMINAL VIOLATIONS OF FEDERAL SECURITIES LAWS ......... 84 CHAPTER 12............5.6 PARALLEL ENFORCEMENT .. 84 5 .......5.............4 NON-SECURITIES CRIMINAL LAW 84 APPLIED TO SECURITIES ACTIVITIES CHAPTER 12.......5.........
(4) ³Issuer´ means every person who issues or proposes to issue any security. gas. stock. ³Offer to sell´. or privilege on any security. (10) ³Prospectus´ means any prospectus.I. and the insular possessions of the United States. or any put. or any certificate of interest or participation in. (6) ³Territory´ means Puerto Rico. or the District of Columbia. evidence of indebtedness. advertisement. (9) ³Write´ or ³Written´ shall include printed. the Virgin Islands. letter. receipt for. debenture. or other mineral rights. for value. investment contract. Except that (a) a communication sent or given after the effective date of the registration statement (other than a prospectus permitted under subsection (b) of section 10) shall not be deemed a prospectus if it is proved that prior to or at the same time with such communication a 6 . treasury stock. a security or interest in a security. transferable share. certificate of deposit. bond. any interest or instrument commonly known as a ³security´. (3) ³Sale´ or ³sell´ shall include every contract of sale or disposition of a security or interest in a security. any of the foregoing. circular. certificate of interest or participation in any profit-sharing agreement. DEFINITIONS (1) ³Security´ means any note. or solicitation of an offer to buy. temporary or interim certificate for. and any underwriter. certificate of deposit for a security. option. or within the District of Columbia. or (ii) among underwriters who are or are to be in privity of contract with an issuer or its affiliates. or group or index of securities (including any interest therein or based on the value thereof). or. or between any foreign country and any State. voting-trust certificate. Territory. preorganization certificate or subscription. or privilege entered into on a national securities exchange relating to foreign currency. call. which offers any security for sale or confirms the sale of any security. The terms defined shall not include preliminary negotiations or agreements between (i) an issuer or its affiliates. (7) ³Interstate Commerce´ means trade or commerce in securities or any transportation or communication relating thereto among the several States or between the District of Columbia or any Territory of the United States and any State or other Territory. for value. or warrant or right to subscribe to or purchase. straddle. security future. written or by radio or television. or ³Offer´ shall include every attempt or offer to dispose of. lithographed. any put. or any means of graphic communication. collateraltrust certificate. guarantee of. call. in general. fractional undivided interest in oil. ³Offer for sale´. option. notice. straddle. or communication. DEFINITIONS SECTION 2.
or indirectly through one or more intermediaries. on the basis of such factors as financial sophistication. directly or indirectly. does no more than identify the security. or otherwise [Management Power]. ³Control´ (including the terms controlling. RULE 405 ³Affiliate´ is a person that directly. selling. or participates or has a participation in the direct or indirect underwriting of any such undertaking. (v) an employee benefit plan. direct or indirect. and (b) a notice. or amount of assets under management qualifies as an accredited investor. (15) ³Accredited Investor´ shall mean: (i) a bank whether acting in its individual or fiduciary capacity. or communication in respect of a security shall not be deemed to be a prospectus if it states from whom a written prospectus meeting the requirements of section 10 may be obtained and. state the price thereof. as agent. or participates or has a direct or indirect participation in any such undertaking. (12) ³Dealer´ means any person who engages either for all or part of his time. (11) ³Underwriter´ means any person who has purchased from an issuer with a view to. the distribution of any security. or otherwise dealing or trading in securities issued by another person. in addition. controls or is controlled by. and experience in financial matters. net worth. (ii) an insurance company. knowledge. broker. or offers or sells for an issuer in connection with.written prospectus meeting the requirements of subsection (a) of section 10 at the time of such communication was sent or given to the person to whom the communication was made. circular. (iii) an investment company registered under the Investment Company Act of 1940 or a business development company. in the business of offering. or principal. by contract. or (vii) any person who. (iv) a Small Business Investment Company licensed by the Small Business Administration. controlled by and under common control with) means the possession. letter. 7 . but such term shall not include a person whose interest is limited to a commission from an underwriter or dealer not in excess of the usual and customary distributors' or sellers' commission. whether through the ownership of voting securities. or is under common control with. including an individual retirement account. of the power to direct or cause the direction of the management and policies of a person. the person specified. state by whom orders will be executed. buying. advertisement.
limited partnership interest. whether or not such registration statement is filed). a radio or television broadcast. or any such warrant or right. ³Material´. ³Free writing prospectus´ means any written communication that constitutes an offer to sell or a solicitation of an offer to buy the securities relating to a registered offering that is used after the registration statement in respect of the offering is filed (or. transferable share. [Registration Power] ³Equity security´ means any stock or similar security. any security future on any such security. ³Written communication´ means any communication that is written. in the case of a well-known seasoned issuer. interest in a joint venture. printed. or any security convertible. or other option or privilege of buying such a security from or selling such a security to another without being bound to do so. or certificate of interest in a business trust. or a graphic communication as defined in this section. or any put. certificate of interest or participation in any profit sharing agreement. straddle. voting trust certificate or certificate of deposit for an equity security. with or without consideration into such a security. call. preorganization certificate or subscription. limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered. when used to qualify a requirement for the furnishing of information as to any subject. 8 .Person with the power to obtain the signatures of those required to sign a registration statement. or carrying any warrant or right to subscribe to or purchase such a security.
1. CHAPTER 1. Diversity and hedge investments 9 .1 Two types of markets: (a) Primary market. (b) Liquidity.2 FUNCTIONS OF SECURITIES MARKETS Securities markets have three basic functions: (a) Capital formation. ³Exchange Market´ is the centralized location where buy and sell orders arrive and where specialists maintain book of orders.1. SECURITIES TRANSACTIONS CHAPTER 1. Is divided in public or private placements. Public corporations issue trading-restricted securities (debt) to institutional investors.1 SECURITIES MARKETS AND PARTICIPANTS CHAPTER 1. (b) Secondary market. Ability readily to sell and investment instrument (c) Risk Management. PRIMARY AND SECONDARY MARKETS CHAPTER 1. INTRODUCTION Securities regulation is provided in federal laws and its objective is to protect investors. Investors liquidate investments by selling securities to other investors in private or public trading markets. Issue ownership interests to its founding members. Buy-sale transactions among investors. ³Over-the-counter Market´ is the location where selling and buying occurs between securities firms (on behalf of investors) through electronic means. Sales of securities by issuers to investors. y Private Placements. Issue stock to venture capitalist in exchange of an ownership position and a management role.II.
financial institutions. CHAPTER 1. (c) ³Financial Intermediaries´ are broker-dealers. (b) Call Option. non-profit organizations. CHAPTER 1. Persons who own securities directly or indirectly. insurance companies. securities firms and foreign investors. investment advisors. 10 . and mutual funds.4 INTERCONNECTION AMONG FINANCIAL MARKETS Regulatory competition exists because investors and issuers migrate if the market is too regulated. investment companies and investment banking firms. (c) Futures Contracts. CHAPTER 1. pension and mutual funds. Promise to purchase at the option of the seller. Regulatory overlap states how different regulators assert jurisdiction over the same financial transaction (federal vs. Stock patterns random. state and local governments. state and local governments.³Derivative Securities´ are financial instruments whose prices are derived from pieces of underlying securities. This is the reason why trading with institutional investors or debt issuance has become more popular. Particular information affects the market price of a stock as though everyone had the same information at the same time. corporations.1. Agreement to buy or sell a particular commodity at a fixed price on a specific date. (a) Put Option. ³Institutional Investors´ are persons who own securities on behalf of others (i. Promise to sell at the option of the buyer.2 EFFICIENCY OF PUBLIC STOCK MARKETS ³Efficient Capital Market Hypothesis´ Prices of the stock are determined by the public information known and assimilated by the market. investors cannot draw charts of past prices nor to extrapolate future prices.e.3 PARTICIPANTS (a) ³Investors´.1. (b) ³Issuers´ Individuals (through securitization). Persons who seek return of investments. blue sky laws). (a) Weak Efficiency. federal agencies.
(c) Strong Efficiency. Market promptly impounds all publicly available information. 11 . Information impounds as if received by everyone at the same time.(b) Semi-Strong Efficiency.
Additionally. The Securities Act was drafted as a disclosure statute over a weekend by a professor and 3 former law students. which had lost almost all of their value in the Great Depression. 12 . SECURITIES REGULATION CHAPTER 1. The Securities Act focused on disclosure through the registration/filing of a Prospectus.1 SECURITIES ACT OF 1933 The Securities Act was the first bill drafted by the Federal Trade Commission Commissioner Huston Thompson. CHAPTER 1. Failure to do so carried criminal penalties. Roosevelt started his administration in 1933 and had the burden to fill the gaps in state law and Wall Street¶s self regulation. the SEC reached a unified approach to disclosure under both acts. they drafted far-reaching liability for participants in securities offerings. Regulation S-K for non-financial disclosure and Regulation S-X for accounting information.3.III.3 FEDERAL SECURITIES REGULATION ± OVERVIEW The federal securities laws grew out of the public outcry for reform of the securities markets. the Securities Act and the Exchange Act lived in separate worlds regarding disclosure.2 SECURITIES EXCHANGE ACT OF 1934 The Exchange Act covered a number of fronts: y y y y y y y The creation of the SEC Regulation of the securities industry (Stock Exchange and Securities Firms) Regulation of margin for the purchase of securities Prohibition against price manipulation Periodic disclosure (reports) Regulation on proxy voting in public companies Regulation of insider trading Integrated Disclosure During 50 years. In 1982. The final statute maintained the ³Thompson Bill´ but inserted a disclosure scheme from the English Companies Act of 1929. From 1932-1934 the Senate Banking Committee held hearings on securities market practices. CHAPTER 1. administrative sanctions and private civil liability. The ³Thompson Bill´ focused on informed investors rather than government paternalism. President Franklin D.3.
CHAPTER 1. and (2) Enron financed these related entities with loans (secured by its high-priced stock) that were reported as debt on Enron¶s balance sheet. (d) Investment Advisers Act of 1940 Regulates broker-dealers. typically a bank).3.Audited Financials The Securities Act and the Exchange Act with a philosophy of leaving the responsibility for sound securities practices to self-regulatory private actors. Its executives devised two main techniques: (a) Enron entered into paper transactions with specialpurpose related entities that created the appearance of revenues on Enron¶s financial statements.4 SARBANES-OXLEY ACT OF 2002 Sarbanes-Oxley is an act that responded to the accounting and corporate scandals of the early 2000s. A registry called the Public Company Accounting Oversight Board was created. call for financial statements to be audited by public accountants. CHAPTER 1. 13 . The Sarbanes-Oxley Act created a new regulatory structure for accountants that audit financial statements. (c) Investment Company Act of 1940 Regulates investment companies. Pavlovian Response to Enron Enron had to look for new ways to maintain its constantly growing profits due to competition. (b) Trust Indenture Act of 1939 Regulation of indentures (agreements) between the issuer of debt securities and the administrator of debt issue (trustee.3 SPECIALIZED SECURITIES LAWS (a) Public Utility Holding Company Act of 1935 Break up holding companies in the gas and electric utilities industry.3. It seeks to strengthen the integrity of the federal securities disclosure system and to federalize specific aspects of public corporation law.
It may initiate court action or refer matters for criminal prosecution. Greater confidence in the information contained in SEC filings certified by company officers. Corporate Governance Sarbanes-Oxley moved into areas of corporate governance historically within the domain of state corporate law. CHAPTER 1. the provisions that (1) specify the composition and responsibilities of the audit committees. and reduced its income by $600M and increased its debt by $628M. Evaluation of Sarbanes-Oxley Few enforcement actions have been brought under the Act. (b) Legislative Authority. accounting and legal communities responded heavily to its many requirements. The SEC is headed by 5 commissioners appointed by the President and confirmed by the Senate. (c) Judicial Authority. 14 . NASD and other self-regulatory organizations). created under the Exchange Act and embodied with executive. The SEC promulgates (i) rules. Bankruptcy soon followed. The business.5 SECURITIES AND EXCHANGE COMMISSION The SEC is an independent agency. (3) the forfeiture of executive pay after financial restatements.3. regulation and guidelines with force of law. and order disgorgement of profits in administrative proceedings. impose fines. and (iii) interpretative letters and no-action letters to provide views and guidance to securities transaction planners.In 2001. Disclosure vs. Regulation and Technology EDGAR (Electronic Data Gathering Analysis and Retrieval) is a computer system to file documents in electronic form. (a) Executive Authority. (2) the restrictions on loans to corporate executives. The SEC administers and enforces federal law. The SEC has original jurisdiction and appellate jurisdiction (actions taken by the stock exchanges. legislative and judicial authority. For example. Enron restated its financials for the previous four years. Empirical studies indicate that investors have responded favorably to some of the Act¶s initiatives. not part of the President¶s cabinet. (ii) interpretative releases concerning view points of statutes (no force of law). It has investigative powers and may issue cease-and-desist orders. and (4) limitations on trading by executives during blackout periods.
reports or filing fees are permitted. consent to service of process and filings of sales reports and other documents similar to those filed with the SEC. CHAPTER 1. On (b)-(d). filings. Class actions involving allegations of securities fraud in publicly traded securities must be litigated exclusively in a federal court.5 SEC EXEMPTIVE POWER SEC may exempt particular persons and transaction from regulation under the federal securities laws. States may require fees. whereas the day-to-day regulation of securities is handled by firms themselves and by private membership organizations. Securities listed on a stock exchange or quoted on NASDAQ. ³Covered Securities´ are securities that may not be subject to state regulation. (d) Exempt Offerings. 15 . Unless the exemption anticipates states¶ regulation. Plain English Initiative The SEC enforces the ³Plain English´ Initiative in disclosure documents for investors.4 STATES SECURITIES REGULATION ± BLUE SKY LAWS ³Blue Sky Laws´ are state statutes establishing standards for offering and selling securities. ³Delaware Carve-out´ State cases alleging fiduciary breaches under state corporate law may be brought before a state court.SEC Partnership with Securities Industry The SEC is responsible for the big picture. Securities issued by ³registered investment companies´. There are parallel statutes on state regulation to those on federal regulation. (b) Mutual Funds. (c) Private Placements. Sales to QIBs. CHAPTER 1. Performs targeted oversight while others regulate directly. There are 4 categories of ³covered securities´: (a) Listed Securities. no state registration. Most of such statutes are antifraud rules.
A broker is any person (without including a bank) engaged in the regular business of effecting securities transactions for the account of others.1 CAPACITIES OF SECURITIES PROFESSIONALS Securities intermediaries act in three capacities pursuant to the definitions of the federal securities laws: (a) ³Broker´. (b) ³Dealer´.CHAPTER 11. REGULATION OF SECURITIES INDUSTRY Securities professionals (broker-dealers and investment advisers) are subject to an imposing array of regulation to ensure honesty. (c) ³Investment Adviser´. An investment adviser is a person who. buying or selling securities. CHAPTER 11. for compensation. 16 . engages in the business of advising others on investing. A dealer is any person (without including a bank) engaged in buying and selling securities for his own account as part of his regular business. competence. integrity. and financial capacity for the protection of investors.
2.Section 2. 17 . Returns most derive ³solely´ from the efforts of others. lower courts have accepted investor¶s efforts may contribute to profits. CHAPTER 2. The efforts of the managers. must be predominant (investors mostly passive).1 IMPLICATIONS OF DEFINITION A transaction that involves a security triggers federal and state securities regulation.2. over which the investor has no managerial control. 293) Supreme Court defines an ³investment contract´ as ³any transaction in which (1) a person invests money (2) in a common enterprise and (3) is led to expect profits (4) solely (predominantly) from the efforts of others.S. An investment. (4) Efforts of others. CHAPTER 2. which can be cash or noncash consideration. Vertical ± Single investor has a common interest with the manager of its investment. The expected returns (either fixed or variable) must come from earnings of the enterprise and must be the principal motivation for the investment. W.2 TESTING FOR A SECURITY Definition in Securities Act . is expected to produce income or profit.IV. The ³risk capital´ test focuses on the extent to which the investor¶s initial outlay is subject to the risks of the enterprise.2 RISK CAPITAL TEST Used by State courts to identify when their blue sky laws apply to unorthodox transactions.Multiple investors have interrelated interests in a common scheme. Neither the commonality nor the profits be derived from the efforts of others are considered in this test. (328 U. SECURITY CHAPTER 2. Howey Co. DEFINITION OF A SECURITY CHAPTER 2. (2) Commonality. (3) Expected profits. (1) Investment.J. CHAPTER 2.1 INVESTMENT CONTRACTS (CATCH ALL) ± THE HOWEY TEST SEC v. however. however. Horizontal (pools) .
as such.g. a note that arises out of a current transaction and that matures within 9 months is exempt from registration under the Act. with limited rights of occupancy.3. 18 . financially sound companies to finance current operations and sold to institutional investors in large denominations. and to receive a pro rata share of net rental income from a pool of all rentals in the complex. CHAPTER 2. Such exemption is intended for ³commercial paper´ which are unsecured promissory notes issued by large. many extensions of credit do not have the typical attributes of an investment.CHAPTER 2. courts have applied the Howey Test when the marketing to purchasers emphasizes the economic benefits to be derived from the managerial efforts of the promoter from the rental of units. represents the creditor¶s investment in the borrower. however.3.1 REAL ESTATE AS SECURITIES The sale of real estate (without any collateral arrangements with the seller) is not a securities transaction.3 SECURITIES IN VARYING CONTEXTS CHAPTER 2.3. Promissory notes under consumer and commercial financing transactions should not be treated as securities. the property sale does not involve a security.4 NOTES AS SECURITIES A note evidences a borrower¶s promise to repay a debt (extension of credit) and. E. A Note is included within the definition of Security under the Securities Act. Developer offers resort condos under an arrangement in which purchasers agree to make their property available for rental. Under the Securities Act.2 BUSINESS INTERESTS AS SECURITIES Whether ownership interests in a typical business organization are securities depends on the legal form: Form Corporation Limited Partnership Partnership (Joint Venture) Security Common and Preferred Shares Limited Partner Interests General Partner Interests Partner Interests Co-venturer interests Not Security CHAPTER 2. If there is no pooling of rents and condo purchasers have control over rental arrangements. nonetheless.
it is more likely that it is not a security. Sale-Leaseback Financing A financier agrees to nominally purchase an asset used by a business and receive fixed lease payments for a specific period. SEC v. it is more likely not a security. along with a five-year agreement for the management and the buyback of the payphone. If the note is not collateralized and not subject to nonsecurities regulation. If the issuer uses the proceeds of the note for general business purposes. it is more likely a security. a sale-leaseback is not viewed as a security. Family Resemblance Test provides four factors to determine the ³family´ into which a note fits: a. it is more likely a security. Commercial notes are in the ³family´ of nonsecurities.In order to know if a note is a security.000 people invested in a scheme where purchasers were offered a payphone. not merely in the maturity. c. If investors generally view the type of notes to be investments. Other factors reduce risk. even when the scheme involves a contractual promise to pay a fixed rate of return. after which the lease terminates and the asset must be repurchased by the business. If the notes are secured or otherwise regulated (such as banking regulation) it is more likely not a security. If it uses it to buy consumer goods or for ³commercial´ purpose. but instead as a form of secured financing. Reves v. Edwards (540 US 389) A sale-leaseback arrangement for payphones can constitute an investment contract under the Howey Test. Reasonable expectations of investing public. d. Plan of distribution. Motivation of seller and buyer. 19 . If the notes are widely offered and traded. If the note is given in a face-to-face negotiation to al limited group of sophisticated investors. more than 10. b. In the case. it is more likely a security. Ernst Young (494 US 56) Family Resemblance Test It begins with a rebuttable presumption that every note is a ³security´ unless it falls into a category of instruments that are not securities. it is more likely a security. it is important to focus on the economic realities of the transaction. Normally.
Golden v. Forman (421 US 837) A security must reflect ³economic reality´. residents were bound to sell their share back to the corporation at its original price. Residents were entitled to one vote regardless of the shares they held. At the end. Poloway (637 F. Additionally the Courts applied the Howey Test and it lacked the ³expectation of profits´. Cooperative housing corporation which required residents to buy ³shares´. The Court ruled that the ³shares´ were not securities since it was not a stock investment since: (1) There was no right to dividends. 20 . Under the ³sale of business´ doctrine. (2) shares were not negotiable.2d 1139) Stock is stock no matter how it is transacted. however.3. Noninvestment Stock United Housing Foundation v. ³Sale of Business´ Doctrine Should a stock purchase acquisition be treated as a securities transaction? Fredricksen v. The term ³stock´ is included in the Securities Act definition. and (4) the shares could not appreciate in value. courts have held that not all instruments labeled ³stock´ are securities. even though there was no promise of capital appreciation or participation in business earnings. the courts looked to Howey¶s emphasis on management to conclude that the sale of a majority interest passes complete control to purchaser. CHAPTER 2. however. the underlying economic basis must be analyzed.2d 1147) During the µ80s lower courts concluded that the transfer of a majority of the stock of a private company is not a securities transaction.6 ³STOCK´ AS A SECURITY Must stocks are securities.An investor contract could involve one that promised a fixed rate of return. (3) voting rights were not proportionate to the number of shares held. who becomes an owner-entrepreneur and not an investor. Garafalo (678 F.
Wielgos v. Companies offering securities to the public and reporting companies that have publicly traded securities must provide line-item disclosure in SEC filings. ³Substantial likelihood´ connotes that the information ³probably´ would have been important to a reasonable investor. rather than irrational investors.3 RELATIONSHIP OF MATERIALITY AND DUTY TO DISCLOSE Just because information is material does not mean it must be disclosed. Unless there is a duty to disclose. CHAPTER 3.2d 509) The Court held that omitted information about regulatory proceedings that resulted in costly delays for utility¶s power plants was not material since securities analysts already knew of the proceedings and their risks.1 DEFINITION OF MATERIALITY CHAPTER 3. Disclosure duties under the federal securities laws can arise in essentially 2 ways: (a) SEC Filing Obligations.1.1. materiality relates to what information must be disclosed. CHAPTER 3. DISCLOSURE AND MATERIALITY CHAPTER 3.1. 21 . CHAPTER 3. Commonwealth Edison Co.1 ³SUBSTANTIAL LIKELIHOOD´ TEST A fact is material if there is a ³substantial likelihood´ that a reasonable investor would attach importance in determining whether to purchase the security registered. Duty relates to whether and when information must be disclosed. the materiality of the information is only of theoretical interest.V. (892 F. MATERIALITY Material information is the only information required by the SEC in order to avoid overload of information without suffering of scarcity.2 REASONABLE INVESTOR The SEC interprets ³reasonable investors´ as professional securities analysts.
Rule 408. The antifraud provisions of the federal securities laws require complete honesty concerning material information whenever one speaks in connection with certain securities transactions. not misleading. Courts have relied on this measure of materiality. CHAPTER 3. 22 . it sometimes does not affect because the information already had been absorbed by the market prior to a formal disclosure. If a company does not speak and has no specific duty to speak. as may be necessary to make the required statements. there shall be added such further material information.2. and (iii) to update statements that have become materially false or misleading. in the light of the circumstances under which they are made. 5% price change). SEC requires reporting companies to include in their filings any other material information necessary to make required disclosure not misleading. Market Reaction A common test for the materiality of company information is whether the market price of the company¶s stock changes on the date the information is first disclosed (whether in a formal report or by the media). Rule 12b-20. The duty of honesty includes (i) not making material false or misleading statements. In addition to the information expressly required to be included in a statement or report. However.e. (ii) to correct materially false or misleading statements. the federal securities laws permit management to keep business information confidential (no matter how material). Off-Balance Sheet Disclosures Sarbanes-Oxley mandates that the MD&A must include off-balance sheet arrangements and known contractual obligations reasonably likely to have a material effect on the company¶s financial condition.2 MATERIALITY ± TYPES OF INFORMATION Despite the prevalence of the ³substantial likelihood´ test.1 HISTORIC INFORMATION When disclosure of past information coincides with abnormal changes in public stock prices. (b) Duty of Honesty. Courts reject arguments that materiality depends on particular quantitative benchmarks (i. Courts assume it was material information. the SEC and the Courts take different approaches to materiality: CHAPTER 3.
2. Voluntary Disclosure of Forward-Looking Information Rule 175. etc. Information is material if its expected value. indicates it would affect investor behavior.2 SPECULATIVE INFORMATION When information is relevant because it portends a future event (mergers. Materiality will depend on the financial significance of the event.CHAPTER 3. This forward-looking information disclosure focuses on a subjective test of what management knows or should know of the future. v. the ³probabilitymagnitude´ test: Basic. ³everyone knows that someone trying to sell something is going to talk on the bright side´. Eisenstadt v. Puffery One kind of speculative information is an overstatement of present circumstances. SEC permits forward-looking information in SEC filings unless it is shown the statement was made ³without reasonable basis´ or disclosed ³other than in good faith´. estimates. or opinions that reflect a look into the future is the most valuable and the most perilous for investors. 23 . Courts have applied a special version of the ³substantial likelihood´ test.2. Rule 3b-6.3 FORWARD-LOOKING STATEMENTS Projections. and an objective test or disclaimers or cautions that accompany future statements. Companies in merger negotiations may remain silent so long as they do not release false or misleading information.). based on a hope that events will turn out well. discoveries. Centel Corp. The idea is to present information through the eyes of management. Inc. such as annual reports and Prospectuses. Federal Courts have been reluctant to treat optimistic statements as misleading. Levinson. discounted by the chances of it actually happening. The MD&A must describe: (a) Trends and uncertainties that are ³reasonably likely´ to result in material changes to the company¶s financial position. CHAPTER 3. discounted by its uncertainty. Mandatory Disclosure of Forward-Looking Information SEC requires the presentation of forward-looking statements in the MD&A of certain SEC filings.
[Item 401. and (3) there is nothing that contradicts the opinion.4 INFORMATION ABOUT MANAGEMENT INTEGRITY Managements¶ experience and integrity are often critical for investment. Compensation. and general expressions of optimism as actionable under the federal securities laws. stock fraud. Stock ownership. (d) Information on the adoption of accounting policies and accounting estimates underlying financial statements. Yet. In general. so investors know whether past performance is indicative of future performance. SEC does not require disclosure of executive¶s criminal behavior unless it has resulted in an indictment or conviction in the last 5 years.2. 24 . A forward-looking statement carries a number of testable factual assertions: (1) the speaker genuinely holds his position. stock pledges as security for personal loans. loans. projections. Lawsuits involving personal insolvency. criminal convictions. unless management misfeasance is clear. forecasts. (b) Management Integrity. In Re Franchard. SEC requires information about [Regulation S-K]: (a) Management Incentives. SEC concluded that disclosure of how the board carried out its state-mandated oversight duties was not matter for federal securities laws. federal securities laws mandates disclosure of compliance with other non-securities norms only if non compliance is clear and would have a financial significance. (2) there exists a reasonable basis for his opinion. Regulation S-K] SEC does not require disclosure of fiduciary breaches. (c) Description of the quality and potential variability of earnings. Forward-looking statements can be seen as false if one of these implicit assertions is false. (c) Management Commitment to the Company.(b) Information that ³keeps management up at night´. CHAPTER 3. Actionability of Forward-Looking Statements The SEC and Federal Courts have treated opinions. 42 SEC 163 (1964) SEC asserted materiality of information while stopping a securities offering for not disclosing serious defalcations and suspicious stock pledges of the controlling shareholder. conflicts-of-interest transactions.
Such code must promote honest and ethical conduct and reporting and disciplining of code violation. 25 .3 MATERIALITY IN CONTEXT: ³TOTAL MIX´ OF INFORMATION Disclosure is contextual. Reporting companies must disclose pending environmental proceedings (private or public) that involve potential damage.SEC has heightened disclosure duties regarding management self-dealing such as disclosure of retirement benefits for board members or officers. Several groups have urged the SEC to include social/environmental and civil rights information as required (e.5 SOCIAL/ENVIRONMENTAL DISCLOSURE SEC disclosure policy focuses on the financial relevance of business information to investors. CHAPTER 3.g. and litigations costs of more than 10% of current assets [Instruction 5 to Item 103. CHAPTER 3. etc). Reg. Any waiver of the company¶s ethic code must be reported promptly on Form 8-K. global warming. penalties. The NYSE & NASDAQ require that all listed companies have a code of ethics and specify its contents. Code of Ethics Sarbanes-Oxley requires that every public company (domestic or foreign) disclose whether it has a code of ethics covering its principal executive and financial officers.2. Whether a company can withhold material information that it has a duty to disclose where the information incriminates company executives. Information revealed in one part of a disclosure document may be tempered or disclaimed in another part. environmental impact.3d 1276) Mandatory securities disclosure is not aimed at undermining the Fifth Amendment privilege since it does not target groups inherently suspect of criminal activities. SEC v. Fehn (97 F. rather than its social and environmental relevance to the public. S-K] Potential liability need not be disclosed.
Food Lion. (892 F. were not materially misleading because professional traders ³surely deduced what was afoot´ and knew to discount management¶s consistently biased optimism. 26 . SEC filings often merely confirm information that is known to securities analysts and already impounded the market prices. material information that is already known to the market is not actionable.´ TSC Industries. through lacking reasonable basis. Longman v. Northway. managers can lie if the market knows it¶s dealing with liars. as discussed in the Efficient Capital Market Hypothesis. ³Total Mix´ in an Efficient Market Securities investors do not depend exclusively on mandatory disclosure. Wielgos v.3d 675) The court assumed that the market was aware of labor violations since they were widely reported in the press. In fact. Inc.2d 509) Truth on the Market Doctrine It is possible that false or misleading disclosure on important company matters is not material if professional securities traders who set the market price know the disclosure to be wrong. ³Buried Facts´ Doctrine Disclosure can be misleading if it contains material information that is inaccessible or difficult to assemble.1 ³TOTAL MIX´ TEST Supreme Court¶s definition of materiality: ³There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ³total mix´ of information made available. Commonwealth Edison Co.3. Inc. In short.CHAPTER 3. (197 F. 438) An omission is not material (even if the information is important to investors) if reasonable investors already know or can infer the omitted information from other disclosure. thus. even though the information came from the company¶s labor union and was denied by the company.. v.S. Inc. Optimistic cost estimates disclosure. (426 U.
3. the court will consider whether the document as a whole is misleading.2 SAFE HARBORS FOR FORWARD-LOOKING STATEMENTS Forward-Looking Statements include (i) projections of revenues and other financial items. 27 . (322 F. Luce v. Trump¶s Castle Funding (7 F. including MD&A statements of financial conditions and results of operation. truth does not neutralize falsity if the truth is hidden or discernible only by sophisticated investors.2d 49) Offering memorandum warned that the projections were ³necessarily speculative´ and not sure to be realized. Andersen (318 F.3d 170) Inaccurate graphs that summarize revenues are cured by accurate financial tables. 1331) Proxy statement to be materially misleading for prominently disclosing an investment adviser¶s favorable opinion. DeMaria v. and (iv) assumptions underlying these statements. However. Supp. (ii) plans and objectives. Kaufman v. but burying in an appendix that the adviser had failed to evaluate the firm¶s assets. American Metal Climax.3d 357) Hopeful statements in a prospectus that operation would be sufficient to cover all of the issuer¶s debt service were considered immaterial due to extensive cautionary statements included elsewhere in the prospectus. sometimes rendering them immaterial. CHAPTER 3. Inc. If a company discloses both accurate and inaccurate information in the same document. (iii) statements of future economic performance. Federal courts have recognized that cautioning statements that identify risks temper forwardlooking statements. ³Bespeaks Caution´ Doctrine´ (Judicial Safe Harbor) Cautionary disclosure (beyond boilerplate warnings) can negate the materiality of or reliance on optimistic prediction. A misleading statement can be discredited by an accompanying true statement.Kohn v. Edelstein (802 F.
and immunizes reckless or negligent statements from private liability. The forward-looking statement was immaterial. (b) Immateriality. The forward-looking statement is identified as a forwardlooking statement and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected. It allows the ³bespeaks caution´ doctrine as a separate basis for immunity. Statutory safe harbors do not apply to IPOs.3d 727) Courts have stated that forward-looking statements made with actual knowledge of their falsity are actionable. Boilerplate cautions are not applicable.Private Securities Litigation Reform Act (PLSRA) Safe Harbor (Statutory Safe Harbor) The PSLRA immunizes public companies and their executives from civil liability (but not administrative liability) for forward-looking statements that turn out to be wrong. (377 F. tender offers. The PSLRA provides 3 safe harbors: (a) No actual knowledge. even if they are accompanied by cautionary statements. It applies only to reporting corporations not to Partnerships or LLCs. going private transactions. Baxter Int¶l. beneficial ownership reports under Section 13(d) or offerings by blank check companies. (c) Cautionary Statements. 28 . Safest safe harbor since it does not consider knowledge or materiality. Inc. Asher v. either oral or written. were false. The plaintiff fails to prove the defendant had actual knowledge that the forward-looking statement.
1 TYPES OF PUBLIC OFFERINGS (a) Standby Underwriting. The issuer offers securities to the public and the underwriter buys the securities not purchased by the public. CHAPTER 4. Dutch Auction.1. the offering price is typically set below the market price to assure the issue clears (save LOBs or Tender Offers). (c) Firm Commitment Underwriting. There may be ³all or none´ or ³minimum percentage´ underwriting. the issuer sets the price at the lowest bid that clears the offering. Issuer offers and underwriter seeks for investors on a ³best efforts´ basis. When auction finishes. (d) Auctioning Securities. The underwriter buys securities from issuers and resells to the public. REGISTRATION OF SECURITIES OFFERINGS CHAPTER 4. 29 . Highest bidders get the securities they offered to buy and the clearance price bidders get the remainder on a pro rata basis. risk is allocated on an underwriting syndicate under the leadership of a managing underwriter. This form is used by small underwriters not willing to risk buying the offered securities and not being able to sell. In the long-term. ³Spinning´ is when the underwriter allocates the securities offered to preferential investors for future business.1. Underwriters earn the spread among the price they paid and the price to which they sold the securities. Normally. Irregular IPO activities: ³Flipping´ is when initial investor sells on the first day of an IPO.VI. The issuer sells to the highest bidders until if fills the offer.1 REGISTRATION OF SECURITIES OFFERINGS CHAPTER 4. Investors bid for the number and price of the securities offered.2 PRICING AND COMMISSION IN A PUBLIC OFFERING The price of the securities depends on whether there exists and established market for such securities. Underwriters underprice IPOs to ensure the issue clears and create profit opportunities for initial purchasers. ³Quid pro quo Arrangements´ are arrangements where the underwriter allocates securities to investors who at the same time pay big commissions. All of the investors buy at clearance price. (b) Best Efforts Underwriting. IPOs are regularly overpriced. For securities already offered. (a) Inefficient Pricing of IPOs.
(g) Selling-Group Agreements. authorization of the offer and issuance of securities and no undisclosed contingencies). Agreement among the syndicate of underwriters providing for compensation and liabilities. (d) Comfort Letters. Executed among the issuer and the underwriter. Describes through the means of a Prospectus the issuer and the offering to be made. This option helps stabilize prices if underwriter buys back securities in the aftermarket. 30 .3 DOCUMENTATION IN A PUBLIC OFFERING (a) Letter of Intent. Adapt company¶s structure. Underwriters demand comfort letters from accountants (typically for unaudited financial statements included in the prospectus) and from lawyers (typically regarding due incorporation. Underwriter may buy additional securities from the issuer if demand exceeds the initial offering capped to 15% of the total offering. (e) Agreement among Underwriters. capital and financial information to that required by the SEC. (b) Issuer Housekeeping. amount of securities to be offered and each participating underwriter¶s allotment.1. CHAPTER 4.³Laddering´ is when the underwriter allocates securities offered with the promise of buying the securities back while in the aftermarket. Agreement among the underwriters and securities firms who will act as retail dealers in the offering. Agreement among issuer and managing underwriter providing for specific price. (c) Registration Statement. ³Green Shoe Option´ (Over-allotment option). (f) Underwriting Agreement.
1 SECTION 5 OF THE SECURITIES ACT (a) Sale or delivery after sale of unregistered securities Unless a registration statement is in effect as to a security. by any means or instruments of transportation. or 2. or while the registration statement is the subject of a refusal order or stop order or (prior to the effective date of the registration statement) any public proceeding or examination under Section 8. any such security for the purpose of sale or for delivery after sale. unless accompanied or preceded by a prospectus that meets the requirements of Section 10(a). (b) Necessity of prospectus meeting requirements of section 10 It shall be unlawful for any person. it shall be unlawful for any person. 31 . The Exchange Act on the other hand. directly or indirectly: 1.2 REGISTRATION OF PUBLIC OFFERINGS Before securities can be offered or sold to the public. directly or indirectly: 1. unless a registration statement has been filed as to such security.CHAPTER 4. to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to carry or transmit any prospectus relating to any security with respect to which a registration statement has been filed under this title. to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise.2. to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to offer to sell or offer to buy through the use or medium of any prospectus or otherwise any security. CHAPTER 4. to carry or cause to be carried through the mails or in interstate commerce. (c) Necessity of filing registration statement It shall be unlawful for any person. calls for the registration of any class of publicly traded equity securities and operates to register public companies. unless such prospectus meets the requirements of Section 10. to carry or cause to be carried through the mails or in interstate commerce any such security for the purpose of sale or for delivery after sale. or 2. the issuer must file a registration statement with the SEC and provide investors a detailed Prospectus. directly or indirectly.
CHAPTER 4. Issuer prepares for the offering. seasoned companies that have been reporting for at least 1 year and. The form permits the prospectus to incorporate by reference information from the company¶s annual report and other period reports under the Exchange Act. information may be incorporated by reference if they are current with their Exchange Act filings. (ii) their common stock is listed on a national stock exchange. the written consent of such person shall be filed with the registration statement. as well as the latitude they give registrants to incorporate by reference information contained in other SEC filings. If any person whose profession gives authority to a statement made in the registration statement. 32 . Also available to issuers (that are not shell companies) with less than $75M public float if (i) have been a reporting company for 12 months. ³Public Float´ is the aggregate market value of the company¶s equity securities held by public investors who are not insiders or affiliates of the company. (b) Waiting Period. (c) Posteffective Period. the information and documents provided in Schedule B. Regarding reporting issuers.2. if offering new securities. and (iii) they issued more than 1/3 of their public float in a 12-month period. but is not yet effective. Investors only receive a prospectus describing the particular offering. The forms are the following: Form S-1 (F-1 for foreign issuers) Form S-1 is the most detailed set of instructions and must be used by non-reporting issuers (making and IPO).2 CONTENTS OF REGISTRATION STATEMENT Section 7 provides that the registration statement of a security to be offered by a domestic issuer must contain and be accompanied by the documents specified in Schedule A. Regarding foreign issuers. Registration statement is filed with the SEC. that have a ³public float´ of at least $75M. Period after the registration statement has become effective and until the offering finishes. The registration forms under the Securities Act vary in the detail they require. Form S-3 (F-3 for foreign issuers) Available to large.Section 5 separates registration process in to 3 periods: (a) Prefiling Period. or small or unseasoned reporting issuers.
3. 4. thus it must contain information of the issuer and of the securities being offered. 6. ³Plain English´ 1. 33 . and the risk factor section of the Prospectus. Presentation of Information in Prospectuses (a) Information may be provided in any order.2. however. 2. Rule 421. 5. however. (b) Plain English must be used in the front and back pages.3 Prospectus: PREPARATION OF REGISTRATION STATEMENT (a) Must contain SEC requirements and must disclose information. must be set forth in such a fashion as to not obscure any of the required information or any information necessary to keep the required information from being incomplete of misleading. CHAPTER 4. unless the SEC determines an earlier effective date.2. plain English is normally used throughout the whole Prospectus.4 SEC REVIEW OF THE REGISTRATION STATEMENT Under Section 5.Form S-4 Special form for securities issued as a result of a merger or acquisition. The registration statement becomes effective automatically 20 days after its filing. Short Sentences. The statutory scheme of the effectiveness of the Registration Statement is as follows: (a) Effectiveness. the summary. securities may be sold once the registration statement becomes effective. (b) Is a selling document. Everyday language¶ Active voice Tabular presentation of complex material No legal jargon No multiple negatives CHAPTER 4. (c) Must be written with an eye to litigation (litigation document).
rather it issues delaying amendments to the registration statement. SHELF REGISTRATION Rule 415.(b) SEC Review. Rule 473. Conditions: (a) If issuer does not qualify for forms S-3 or F-3. a. (b) Only issuers who qualify for forms S-3 or F-3 may delay their offerings and choose when to sell ³off the shelf´. 2 years for business combinations 34 . No offering activities are permitted when a refusal or stop order is outstanding or the SEC is investigating a registration statement. (c) SEC Oversight. thus continuously delaying effectiveness until (i) an amendment is filed by the issuer providing that such registration statement shall thereafter become effective. In practice. Indefinitely for shelf offering involving preexisting obligations b. creating a charade that the issuer is continuously amending the registration statement. the SEC rarely issues refusal or stop orders. After the filing. and continuous offerings lasting more than 30 days. After its effectiveness. shelf registration is only available for offerings involving preexisting obligations. or (ii) the registration statement becomes effective as determined by the SEC. (c) Time Limit. ³Shelf Registration´ permits registration of securities for later sale if the registrant undertakes to file a post-effective amendment disclosing any fundamental change in the information provided in the original registration statement. the SEC can begin a nonpublic administrative investigation. (ii) there has been sufficient circulation of the preliminary prospectus with underwriters and potential investors. (iii) underwriters meet the net capital requirement under the Securities Act. Before or after its effectiveness. and (iv) the NASD does not disapprove pricing or concessions to securities firms participating in the offering. business combinations. The SEC makes the registration statement effective when the issuer addresses its comments. the SEC may issue a stop order if it notices a defect in the disclosure. and is satisfied that (i) disclosure is adequate. registrants stipulate to a delaying amendment in their registration statements. the SEC has 10 days to review the registration statement for incomplete or misleading disclosure and may issue a refusal order that keeps the registration statement from becoming effective. To accomplish SEC complete review.
the issuer can wait 30 days and made a private offering. Issuers must file a prospectus if there are fundamental changes or when securities are taken off the shelf more than 9 months after the effective date. continuous offerings lasting more than 30 days. within 2 business days after the offer is priced and sold. To take securities off the shelf WSKIS must only file a prospectus supplement that includes any omitted information. (e) Issuers must update public information when securities are taken off the shelf.5 PURCHASES DURING REGISTRATION Regulation M prohibits price manipulation during a distribution by forbidding each participant in a distribution from bidding or purchasing securities that. 3 years for mortgage-backed debt offerings. (2) waiting 30 days to file the registration statement if any offers had been made to non-accredited investors. Rule 155 (b) An issuer that has begun and abandons a private offering before making any private sales may commence a public offering by (1) disclosing this in its prospectus. CHAPTER 4. if the issuer is a large public company and its securities are actively 35 . Updating requirements do not apply to S-3/F-3 issuers if their information is in an Exchange Act filing incorporated by reference or a prospectus supplement is filed under Rule 424(b). Well Known Seasoned Issuers (³WSKIs´) may file an ³Automatic Shelf Registration´ which registration statement becomes effective when filed with the SEC. Regulation M exempts purchases by securities firms participating as underwriters. Any unsold allotments under an old registration statement may be rolled over into the new registration statement. (d) S-3/F-3 must register every 3 years. The withdrawal is automatically effective upon filing unless the SEC objects within 15 days. Rule 155(c) If the public offering is abandoned before any sales. and offering by S-3/F-3 issuers. without SEC review.c. because of their terms.2. can affect the price of the securities being distributed. WSKIs can register an unspecified amount of securities and only need to name the class of securities to be offered and even add new classes of securities to the offering. without filing a new registration statement. Withdrawal of Registration Rule 477 permits easier movement among public to private markets and vice versa.
Section 5 provides: (a) You cannot make offers until a registration statement is filed with the SEC.´ Additionally.3 MANAGED DISCLOSURE DURING REGISTRATION ± ³GUN JUMPING´ Violations of Section 5 during the registration period are known as ³gun jumping´. After the company is ³in registration´. (c) Post-effective Period.traded. no prospectus (unless it complies with Section 10(b)). no deliveries. payment of securities by check will be construed as ³instrument of communication in interstate mails. Inc. no delivery unless accompanied by a prospectus. but it would be almost impossible to carry out a public offering without using jurisdictional means. Fall River Industries. State offers may exist. (502 F. (b) Once the registration statement is filed. After the registration statement is filed. you cannot use a ³prospectus´ unless it satisfies the conditions of Section 10. (c) You cannot make ³sales´ or ³deliveries´ until the registration statement becomes effective. No prospectus (unless it complies with Section 10). The stabilizing purchases must be for the purpose of preventing a decline in the market place. (b) Waiting Period. It also creates an important exemption to the prohibition against purchases during a distribution and permits stabilizing purchases. until the distribution ends and the issuer is no longer ³in registration´. Quiet Period. Kerbs v. No sales. CHAPTER 4. no sales. No offers. but before it becomes effective. no deliveries. and then the ³deliveries´ must be accompanied by a final prospectus. After the registration statement becomes effective.´ 36 . Three periods under Section 5: (a) Pre-filing Period.2d 731) Intrastate phone calls involve the use of an ³instrument of communication in interstate commerce. Jurisdictional Means Section 5 reaches only activities that use ³means or instruments of transportation or communication in interstate commerce or of the mails´. but before the registration statement is filed.
or solicitation of an offer to buy. Required to file under the Exchange Act.3. (b) No offers. No offer to sell or offer to buy. for value. blank-check companies. Not required to file under the Exchange Act. No disposition of a security for value. Issuer Categories under the 2005 Reforms The 2005 Public Offering Reforms identify 4 categories of issuers. (c) Seasoned reporting issuers. The SEC has also certified that merely including information on a Web site in close proximity to a Section 10 prospectus does not. Distinction due to efficiency of the market.´ 37 . CHAPTER 4. or (ii) if issuing non-convertible debt. The activities permitted during the registration period vary greatly depending on which category the issuer falls because of the degree of market presence of the issuer: (a) Non-reporting issuer. Required to file under the Exchange Act that are eligible to Form S-3 (more than one year since going public and a $75 million public float). $1 billion in debt issues in the last 3 years. (d) Well-known seasoned reporting issuers (WKSIs). make the information an ³offer to sell´. but not eligible for Form S-3. by itself.Electronic Offerings Issuers and securities firms provide information to investors using electronic means. a security or interest in a security. penny-stock issuers and shell companies are ineligible to use the communication exemptions. Reporting companies that are not current with Exchange Act filings.1 Prohibitions PRE-FILING PERIOD (a) No sales or deliveries. Section 2(a)(3) defines offer as ³every attempt or offer to dispose of. An issuer can even become responsible for third-party information if its Web site links to that information. (b) Unseasoned reporting issuers. Seasoned reporting issuers that have either (i) $700 million worldwide public float.
issue factual press announcements. considering the following factors: i. (d) Research Reports. The underwriters were sanctioned for violating Section 5 and ³arousing and stimulating investor/dealer interest´. Rule 168. It is a use safe harbor. iii. filing Exchange Act reports. to make periodic and other disclosures under the Exchange Act. All while avoiding future-looking statements and valuation opinions. ii. and respond to regular inquiries. Permissions (except Investment Companies) (a) Preregistration Communications (Rule 163A). including advertising products. Includes financial due diligence of issuer by underwriter. Issuers may continue ordinary course communication. Rhoades & Co. Release 5180. Limited to regularly-released information. Dissemination must be intended to persons other than investors (the public). Negotiations between issuers and potential underwriters. Reporting companies can also continue to release forward-looking information about the company¶s operations and finances. Not initiate publicity. Talks to internal sales people of the underwriter. but continue to advertise products and services. Communications by or on behalf of an issuer (other than prospective underwriters or dealers) are permitted when made more than 30 days before the registration statement is filed. and (ii) the issuer must take reasonable steps to ensure these preregistration communications are not further distributed or published within the 30-day period. an issuer cannot use this information in a road-show or as offer material. iv. without including forward-looking statements (except Rule 168). (c) Preliminary Negotiations. (b) Regularly-Released information (Rule 169). including to investors. (38 SEC 843) Disciplinary proceeding against 2 underwriters that issued press releases concerning a company that proposed a public offering before the company had filed a registration statement. Loeb. provided that (i) the proposed offering is not mentioned. SEC safe harbor rules give guidance to securities firms and their analysts to permit the flow of information to securities markets when an issuer is ³in registration´: 38 . Arranged after a financing decision Was broadly disseminated Included forward-looking information of the issuer or its business Mentioned the planned offering In re Carl M.SEC release: any publicity that may contribute to conditioning the public mind or arousing public interest in the offering constitutes an offer.
manner. (f) WKSI Communications (Rule 163).a. May as well issue industry research reports that include reporting companies that are in registration (Rule 139(a)(2). if the offering is for fixed-income securities and vice versa. Available until filing. WKSI may make oral offers during registration and can make written offers that bear a legend (where to get prospectus. Securities firm participating in the distribution may issue company-specific research reports if it appears in a regular publication and either (i) the issuer is a seasoned reporting company eligible for Forms S-3 or F-3: (ii) a WKSI. The issuer or security holders may. Must have had included the issuer in previous reports and include a substantial number of other issuers. along with admonition to read it) and are filed with the SEC ± Free Writing Prospectus. v. Bangor Punta Corp. provided that reports are in the regular course of the firm¶s business. or (iii) a foreign issuer either seasoned on a foreign stock market or has a $700 million global public float. shell or penny-stock company. Inc. 39 . WKSI communications remain subject to antifraud regulation and selective disclosures under Regulation FD. Securities firm not participating in the distribution: (i) the report is in the regular course of the firm¶s business. (426 F. Securities firm (even participating in the distribution) may publish reports about the issuer¶s (reporting issuer or foreign issuer. and purpose of the offering.2d 569) Announcement by underwriter that company would offer a package of security valued at ³$80 or more´ violated Section 5 because it went beyond disclosure permitted by Rule 135. Chris-Craft Industries. b. announce (i) the amount and type of security to be offered. not a blank check. and cannot reinitiate coverage during registration. Issuer¶s non-offered securities (Rule 138). shell or penny stock) common stock (or preferred stock convertible into common stock). (ii) the issuer is not a blank-check. (e) Company Announcements (Rule 135). giving no greater prominence to the issuer. Participant research reports (Rule 139(a)(1)). directly or indirectly. c. Available until the filing becomes effective. May not include information regarding prospective underwriters or pricing and must contain a legend that such notice does not constitute an offer. and (ii) the timing. Securities firm must have covered the issuer or its securities. and (iii) the securities firm has received no special compensation directly or indirectly from the issuer (or a potential investor) related to the report. Nonparticipant research reports (Rule 137).
The preliminary prospectus includes all information except pricing and underwriting. You can give specified written information about the issuer. Any written or graphic communication by the issuer or in its behalf (including web postings. The common practice is for participant in an offering to collect indications of interest from investors. Consistent Information and Legend (Rule 433(c)(1)). Allowed under a constitutional perspective (Freedom of Speech. ³Prospectus´ means any communication written or by radio or television. (e) Identifying Statements (Rule 134). May include information beyond that found in the prospectus. BEFORE EFFECTIVENESS) (a) No sales or deliveries. but not live PowerPoint presentations) that satisfies certain conditions: (professor Def: it¶s a second type of 10 (b). and the offering (more detailed than a tombstone ad) if it includes a legend that the registration statement is still not effective and explain who is selling the securities and where to obtain a preliminary prospectus or hyperlink a preliminary prospectus. even though that in the Prefiling Period is not allowed). (b) No prospectus. Rule 430 (in connection with Section 10(b)) allows a preliminary or ³red herring´ prospectus which includes a marginal legend that cautions the securities cannot yet be sold. (c) Summary Prospectus (Rule 431). (f) Free writing prospectus. A selling effort in writing. No use of prospectus unless it meets the requirements of Section 10. mass e-mails. Section 10(b) authorizes the SEC to permit the use during the waiting period of an incomplete prospectus. the underwriters. Condition precedent upon effectiveness of filing is not acceptable in Purchase Agreements.CHAPTER 4. Permissions (a) Oral Offers. which offers any security for sale.2 Prohibitions WAITING PERIOD (AFTER FILING. Rule 433(c)(2) Must include a legend 40 . states its price. not a 10 (A) nor (B) or a sale literature) ( no content are required in it ). Rarely used. (b) Preliminary Prospectus. but not to take checks or otherwise accept orders. Advertisements (typically made in the financial press using tombstonelike border) that state from whom a prospectus may be obtained and do no more that identify the security. No disposition of a security for value. (d) Tombstone Ads.3. Oral selling offers are subject only to antifraud prohibitions. and name the underwriters. but it must not conflict it or other information filed with the SEC. a.
Prospectus Accompaniment (Rule 433(b)(2)). 41 . A communication that satisfies these conditions is deemed a ³prospectus´ under Section 10(b) and may be used during the waiting period. but never receive a preliminary prospectus. For seasoned and WKSIs. authorized. c. or approved information that is prepared and published or disseminated by the media would be considered at the time of publication or dissemination to be a free writing prospectus. Must be filed with the SEC. the prospectus accompaniment condition is eliminated. For non-reporting and unseasoned issuers it must be preceded by a preliminary prospectus (Section 10(b)) or the hyperlink to access it (in IPOs it must include price range). Subject to liability under Section 12. Any written offer for which an issuer or any other offering participant provided. SEC has plug this regulatory hole by making prospectus dissemination a condition to acceleration of the effective date: (a) Rule 460. Filing (Rule 433(d)). No filing requirement if prepared by the underwriter and shown in a face-to-face basis with clients. including any underwriter or dealer. No later than the day of first use (if prepared by the issuer). SEC binds the issuer to ensure that preliminary prospectuses have been made available to all participating underwriters and dealers. after the filing of the registration statement will be a section 10(b) prospectus for purposes of Section 5(b)(1). Rule 164 Post-filing free writing prospectuses A free writing prospectus of the issuer or any other offering participant. ( can¶t conflict with « ) b. Prospectus Dissemination It is entirely possible for an investor to get an oral offer during the waiting period.that advises reading the prospectus and how to obtain a copy. Rule 433(f) Free writing prospectuses published or distributed by media. place an order (written or oral) contingent on the registration statement becoming effective. The issuer or other offering participant must file the written communication with the SEC within 4 business days after the issuer or other offering participant becomes aware of the publication.
provided it is filed within 15 days after effectiveness. (b) Free Writing (Selling Literature). (b) No deliveries. (d) Securities Deliveries. In the case of IPOs (non reporting issuers) brokers or dealers shall deliver a copy of the preliminary prospectus to any potential investor at least 48 hours prior to sending a sale confirmation. (c) Confirmations. b. Communications in the posteffective period which are accompanied by the final prospectus are not deemed a prospectus. For non-cash offerings.(b) Rule 15c2-8(c). Cash offerings ± can omit price-related and offering-related information. (c) Written offers must include Prospectus (Section 10). (c) SEC requires offering participants (if issuer not a reporting company) to send preliminary prospectuses to any investor who is expected to buy (48 hrs. Section 2(a)(10) includes any writing that ³confirms the sale of any security´ within the definition of prospectus.3 Prohibitions POST-EFFECTIVE PERIOD (a) No prospectus unless Final Prospectus (Section 10). ³Not-yet-final prospectus´ (Rule 430A). Section 5(b)(2) requires final prospectus delivery when the securities are delivered. unless it is accompanied by a prospectus meeting the requirements of Section 10. 42 . however. ³Not-yet-final prospectus (Rule 430C). (a) Expanded ³Prospectus´ types. before confirmation of their purchase). CHAPTER 4. Access equals disclosure. unless accompanied by Final Prospectus. Permissions The regulatory game in the post-effective period is prospectus delivery. considering that access (filing prospectus and its availability in the SEC Web site) equals delivery. Section 5(b)(1) permits dissemination of a prospectus that complies with Section 10.3. ³Shelf Registration prospectus´ (Rule 430B) c. the SEC allows: a. A confirmation is necessary to finalize sales under Exchange Act rules and applicable state statute of fraud. Prospectus delivery can be accomplished with a Rule 173 notice. (e).
(a) Sending confirmations and notices of allocations. allocation and settlement. that: (1) The registration statement pertains only to: 43 . Delivery of prospectuses. Incorrect Disclosure When posteffective events make the prospectus misleading it is necessary to analyze whether it is a substantive or a fundamental event. Delayed or continuous offering and sale of securities. Issuers have 15 business days after the effective date to the registration statement to file a prospectus containing the price-related information. If the event is fundamental. the issuer must amend the registration statement and wait for the SEC to declare the amendment effective. if the issuer has filed the prospectus with the SEC: (1) Written confirmations of sales (if made pursuant to Rule 10b-10) and other information customarily included (including notices provided pursuant to Rule 173. including information identifying the securities. After the effective date of a registration statement. Rule 172. Rule 173: All that is required is that issuers. pricing. the following communications are exempt from the provisions of section 5(b)(1) and 5(b)(2) of the Act. If it is a substantive. and (2) Notices of allocation of securities sold or to be sold. provided. and information incidental thereto. (a) Securities may be registered for an offering to be made on a continuous or delayed basis in the future. To allow flexibility. and participating dealers provide their purchasers a notice which provides that the securities are part of a registered offering within 2 days after completing the sale. underwriters. the SEC now permits the final prospectus to omit price-related information.Form of Final Prospectus The prospectus-delivery requirements were to be satisfied by a full and final prospectus contained in the effective registration statement. Rule 415. the registrant can place a sticker on the prospectus with the new information and then file it with the SEC.
44 .1 REGISTRATION UNDER THE EXCHANGE ACT There are 3 triggers that compel a company to register with the SEC and plug itself into the Exchange Act¶s regulation: (a) [Section 12(a). (c) Section 12(g). Size Thresholds.3 REGULATION OF PUBLIC COMPANIES Companies whose shares are publicly traded must register with the SEC thus making them subject to the Exchange Act regulation: (a) Registered companies must file periodic disclosure documents with the SEC [known as ³reporting companies´]. (b) Registered companies must keep records and maintain a system of internal accounting control. and 10% shareholders of registered companies must disclose their trading in the publicly traded equity securities of the company and are liable to the company if they make profits (or avoid losses) from such trading during a 6 month period after purchasing the securities. Listing on Exchange. subsidiary or controlling person. (d) Any person who makes a tender offer for securities of a registered company must make disclosures to the SEC. CHAPTER 8. It shall be unlawful for any member. (c) Registered companies are subject to SEC proxy regulation. officers. (e) Directors.VII.3. broker. Companies whose securities are listed on a stock exchange are compelled to register with the SEC.] (b) Section 12(b). REGISTRATION UNDER THE EXCHANGE ACT CHAPTER 8. or dealer to effect any transaction in any security (other than an exempted security) on a national securities exchange unless a registration is effective as to such security for such exchange. continuous or delayed basis by or on behalf of the registrant. Companies whose class of equity securities are held by more than 500 shareholders and have total assets exceeding $10M must register with the SEC. to the company¶s management and to solicited shareholders. Listing on Exchange. (x) Securities registered (or qualified to be registered) on Form S-3 or Form F-3 which are to be offered and sold on an immediate. The issuer must register within 120 days after the end of the fiscal year when both thresholds are crossed.
state-regulated insurance companies (not listed on a stock exchange or subject to reporting) and non-profit charities. Banks are required to register whether or not they have a listed security. Disclosure includes quarterly financial statements and updated risk factors. or (b) Less than 500 persons. (b) Quarterly Reports. (c) Special Reports. This Form requires disclosure on the following: 45 . Exemptions to Registration Companies are exempt from Exchange Act registration. are compelled to register with the SEC. Disclosure must be extensive. Reporting companies must file annually reports within 60 days for large companies. This Form channels company disclosure material developments into EDGAR on a real-time basis. CHAPTER 8.(d) Section 15(d).3. or such shorter period as the SEC may determine. Registration Statement Filing. after the issuer certifies to the SEC on Form 15 that the class of securities are held of record by: (a) Less than 300 persons. Reporting companies must file special reports within 4 days of the occurring event on Form 8-K. where the total assets of the issuer have not exceeded $10 million on the last day of each of the issuer¶s most recent 3 fiscal years. 75 for medium companies and 90 days for small companies of each fiscal year-end on Form 10-K. Reporting companies must file quarterly reports within 40 days of each the companies¶ three fiscal quarters on Form 10-Q. A reporting company may unregister under the Exchange Act pursuant to Rule 12g-4 which provides that: Termination of registration of a class of securities under section 12(g) of the Act shall take effect 90 days. including registered investment companies.2 PERIODIC DISCLOSURE The three important Exchange Act filings are: (a) Annual Report. Suspension of filing made pursuant to Section 15(d). Companies who file a registration statement which has become effective pursuant to the Securities Acts. Rule 12h-3.
As commanded by the Sarbanes-Oxley Act. Securities-related Events. restructuring changes. Financial-integrity Events. b. 46 . unless you specify in disclosure that no updates will be available. Changes in corporate control. unregistered sales of equity securities. e.a. Operational Events. 10-Q or 8-K. only if there is a material active and serious consideration in change of business strategy. d. Case law provides that (i) if there is a mistake on a Form 10-K. Compensation agreements. Executive Pay. changes affecting directors or principal officers. changes in debt rating. Delisting or transfer of listing. and (ii) there is a requirement to update material information. direct financial obligations or obligations under an off-balance sheet arrangement. compensation arrangements outside ordinary course of business. Financial Events. bankruptcy or receivership. non-reliability of previously issued financial statements or audit report. Governance Events. Entry into (or termination of) definitive material agreements. loss of significant costumer. c. There is a duty to disclose business strategies. Sarbanes-Oxley provides that the SEC must review companies¶ filings at least every 3 years. the issuer has a duty to correct the wrong statement. and (2) it ³fairly presents´ the financial condition and results of operation of the company. Changes in registrant¶s certifying accountant. material modifications to rights of securities holders. material impairments under existing agreements. amendments to bylaws. the SEC has adopted rules requiring the CEO and CFO certify that they reviewed the report and that (1) it does not contain any material statements that are false or misleading. results of operations and financial condition. f. Acquisition or disposition of assets.
EXEMPTIONS FROM SECURITIES ACT REGISTRATION CHAPTER 5. EXEMPTIONS
Exempt securities constitute a huge part of the securities markets. Preliminary Points 1. Exempt offerings remain subject to the antifraud provisions of the securities laws (both federal and state). The SEC can proceed against any seller of securities under Section 17 of the Securities Act (Fraudulent Interstate Transactions). 2. Purchasers of securities (other than exempt government securities) may have a private Section 12(a)(2) rescission remedy for misrepresentation in an offering that can be viewed as a ³public offering´. (Gustafson v. Alloyd Co. (513 US 561)) 3. Rule 10b-5 of the Exchange Act which exposes all transactions to fraud liability, including those exempt from registration under the Securities Act. 4. Exempt offerings remain subject to state blue sky registration.
CHAPTER 5.1 EXEMPT SECURITIES (SECTION 3) The first group of Securities Act registration exemptions focuses on the issuer and the type of securities offered. An exempt security is always exempt from registration, both when it is issued and later when traded: Section 3(a)(2) Government Securities. Securities issued or guaranteed by the US Government or any political subdivision thereof (including the Fed). The Government is exempted from disclosure of information regarding is operation and administration. Rule 15c2-12 of the Exchange Act SEC has imposed a disclosure regime on municipal securities and industrial development bonds requiring securities firms to provide investors an ³official statement´ for offerings above $1 million. Section 3(a)(3) Commercial Paper. Short-term commercial papers (9 months) that are high quality negotiable notes issued for current business operations and typically purchased by banks and other institutional investors, not offered to the general public. Section 3(a)(4) Securities of Not-for-Profit Issuers. Securities issued so long as none of the issuer¶s net earnings benefit a person, private stockholder, or individual. Religious, educational, benevolent, fraternal, charitable, or reformatory purposes (typically tax-exempt organizations).
Securities subject to Non-SEC Regulation. Exemptions on the basis that other regulations offer adequate protection to investors (e.g. securities issued by banks, insurance policies, pension plans regulated by ERISA, certificates issued by bankruptcy trustees pursuant to court approval, and participation interests in railroad cars of a federally regulated common carrier). Section 3(a)(9) Exchange Securities. Except for securities exchanged in a case under Title 11, any security exchanged by the issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange. Section 3(a)(10) Exchange Securities. Except for securities exchanged in a case under Title 11, any security which is issued in exchange for one or more bona fide outstanding securities where the terms and conditions of such issuance and exchange are approved by any court, or by any official or agency of the United States, or by any State or Territorial banking or insurance commission or other governmental authority expressly authorized by law to grant such approval. Section 3(a)(11) State Only. Any security which is a part of an issue offered and sold only to persons resident within a single State or Territory. Section 3(b) Small Offerings. Securities for less than $5,000,000. Section 3(c) Securities issued by small investment company
CHAPTER 5.2 TRANSACTION EXEMPTIONS (SECTION 4) The second group of Securities Act registrations exemptions focuses on the nature of the offering. The securities not themselves become exempt; each time they are transacted, the seller must find a transaction exemption to avoid registration. Primary Offering by Issuers The transaction exemptions apply to primary offerings by issuers (i.e. Intrastate offerings, private placements, certain small offerings, and exchanges by the issuer). Instead, Section 4(1) ³market trading´ exemption, applies to any transaction by a person ³other than an issuer, underwriter, or dealer.´ Burden to Establish Exemption The party seeking a transaction exemption carries the burden to prove it. Integration Principle An issuer cannot slice and dice an offering so that different parts fit separate exemptions, if the offering as a whole fits none. In order to trigger integration, it is important to consider whether the multiple transactions (i) are part of a single plan of financing; (ii) involve the same class of 48
security; (iii) took place at about the same time; (iv) involved the same consideration; and (v) were made for the same general purpose. Safe harbors for integration: (a) Rule 502(a). Sets of sales separated by 6 months are considered separate offerings. (b) Rule 152 (private placement and then subsequently initiate a public offering), (c) Rule 155 (shift from a private to registered offering and vice versa). a. Rule 155(a). Permits the issuer that begins a private offering (but sells no securities) to abandon it and begin a registered offering (30-day waiting period unless the private offering was to accredited or sophisticated investors). b. Rule 155(b). From public offering to private offering (30-day waiting period).
Section 3(a)(11) exempts purely local offerings, those by in-state issuers to in-state purchasers. The in-state issuer must be a person resident and doing business within the state of the offering. The issue must be offered and sold only to persons resident within a single State. The transaction remains subject to blue sky laws. Rule 147 (Safe harbor). Provides guidelines on the definition of ³residence´ and specifies quantitative guidelines for the ³doing business´ requirement. Permits resales after a 9 month holding period. Integration: 6 months apart.
Section 4(2) exempts from registration any offering ³by any issuer not involving a public offering´. Although Congress did not define ³public offering´, courts and the SEC have interpreted the Section 4(2) private placement exemption that registration is unnecessary when investors on their own have adequate sophistication and information to protect themselves. The private placement exemption exists in two forms: (a) Statutory exemption. Section 4(2) (b) Safe harbor rule. Regulation D. 49
Courts have focused on investor qualification, sophistication and access to information about the issuer. SEC v. Ralston Purina Co. (346 US 119) Ralston Purina sold its common stock to employees without registration. Hundreds of employees had bought common stock on their own initiative. The SEC sued demanding that future sales be registered. The Court held that the 4(2) exemption applies when offerees and investors, regardless of their number, are able to fend for themselves. The Court gave as an example ³executive personnel´ with access to the same kind of information as would be available in a registration statement. Most of the employees at Ralston Purina were not fit for this description and future sales had to be registered. Investor Qualification Lower Courts have focused on the investors¶ ability to evaluate investment (given his business background) and on his access to information about the investment (based on the availability of information or the issuer¶s actual disclosure). The less sophisticated the investor, the most disclosure is required; the most sophisticated, the less disclosure is required. Hill York Corp v. American International Franchises, Inc (448 F.2d 680) Exemption requires that investors, no matter how sophisticated, have access to information about the issuer. SEC v. Continental Tobacco Co. (463 F.2d 137) Informed investors with no sophistication. The Court suggested qualified investors must have personal contact with corporate officers. Doran v. Petroleum Management Corp. (545 F.2d 893) Investors must have information comparable to that found in a registration statement.
Prohibition Against General Solicitation Public advertising or open investment seminars are prohibited because not all offerees could be shown to be qualified. Resale Restriction Investors who purchase in a private placement cannot resell to unqualified investors. Securities must be treated as ³restricted securities´. Avoided through notations in the securities¶ certificates and restrictions on record keeping. 50
Regulation D prohibits general solicitations or general advertising. Rule 506. provided there is no advertising or public solicitation and the issuer files a notice with the SEC. Rule 504. CHAPTER 5. Private Offerings subject to SEC Safe Harbor Conditions (Unlimited amount). Regulation A (Rules 251-264). (B) Small Business Stock Compensation Plans (C) Small Business Investment Companies (D) Accredited Investors Offerings (Section 4(6)) Self-operative exemption for offerings up to $5 million made exclusively to accredited investors. financial information is required though may be unaudited) on offerings during any continuous 12-month period having an aggregate price up to $5 million. Securities issued pursuant to Regulation D become restricted securities.3 (A) SMALL OFFERINGS Offerings under $5 Million are exempt from registration. Small offerings Registered or Exempt under State Blue Sky Laws ($1 million).2. Issuer must use an ³offering circular´ (simplified disclosure document.´ There are no limitations on general solicitations.2.4 REGULATION D Regulation D gives detailed guidance on when an offering qualifies for the Section 4(2) private placement exemption. Regulation D (Rules 504 and 505) Offerings for less than $1 million and non-public offerings up to $5 million with 35 or fewer ³nonaccredited investors´. Issues under Rule 505 and 506 must be sold to less than 35 nonaccredited investors. Available only to nonreporting US and Canadian issuers that are no detailed as ³bad boys. 51 . Medium-Size Offering subject to SEC Conditions ($5 million). Rule 505.CHAPTER 5. All nonaccredited investors must receive specified written disclosure. Little use since issuers prefer to use the 4(2) exemption with the 144A safe harbor.
savings institutions. insurance companies.000 (or $300. Regulation D offerings are governed by the integration principle. and expect to have. (b) Big Organizations. The directors.Issues under Rule 506 add one condition. (e) Fat Cats. (g) Sophisticated Trusts.000 with spouse). brokerage firms. (d) Millionaires. an annual income of $200. executive officers. Banks. gets counted as one nonaccredited purchaser. (h) Accredited-Owned Entity. The issuer must file a notice (Form D) to the SEC regarding an offering in reliance in Regulation D. (f) Venture-Capital Firms. Regulation D creates a safe harbor against integration for offers and sales occurring 6 months apart. Tax-exempt organizations and for-profit organization with more than $5 million in assets. Individuals who have had for two years. 52 . each nonaccredited investor (alone or with an independent purchaser representative) must have sufficient knowledge and experience in business and financial matters so he can evaluate the merits and risks of the investment. Trusts with over $5 million in assets and run by sophisticated managers. An entity in which all the equity owners are accredited investors. and general partners of the issuer. Individuals who have a net worth (along with spouse) of over $1 million. Firms that invest in start-up companies to which they make available ³significant managerial assistance. carried out through different channels. mutual funds and certain ERISA employee benefit plans. A single nonaccredited investment decision. (c) Key Insiders. Rule 501(a) sets out categories of accredited investors: (a) Institutional Investors.
and dealers. Dealer. CHAPTER 7. it is important to understand the concepts of ³control securities´ and ³restricted securities´. Offers or sells for an issuer (or its affiliates) in connection with the distribution of any security. AND DEALERS Section 4(1) Securities Act. 4. Has purchased from an issuer (or its affiliates) with a view to the distribution of any security This category deals with the resale of restricted securities (or control securities). Participates or has a participation in the direct or indirect underwriting of any such undertaking. the Securities Act regulates sales by control persons in much the same way it regulates sales by issuers. Issuer. 53 . ³Restricted Securities´ are securities originally acquired in a nonpublic distribution. SECONDARY DISTRIBUTIONS CHAPTER 7. See Definitions. ³Control Securities´ are those owned by a control person. When a control person sells his securities to public investors. 3. underwriters. Underwriter. For this reason. UNDERWRITERS.1 DEFINITIONS OF ISSUERS. Means any person who: 1. there is the understandable concern that he can exploit his superior informational position. either from the issuer or a control person that may not be resold into a public trading market without registration or another exemption. who the SEC rules refer to as an affiliate of the issuer. The provisions of Section 5 shall not apply to transactions by persons other than issuers. 2. SECONDARY AND OTHER POSTOFFERING DISTRIBUTIONS To understand the boundary between regulated distributions and unregulated market trading.IX. Participates or has a direct or indirect participation in any such undertaking. This category deals with assistance in de facto distributions (or control securities). See Definitions.
Compensation from the issuer is not a condition to be an underwriter ³for an issuer´. the sales efforts by the Chinese government were regulated ³transactions by an issuer´ and any steps to their distribution. ³Distribution´ as defined by the Courts.g. Investment banker in a µfirm commitment´ offering who purchases from the issuer and resells his allotment to retail dealers or directly to investors.2 PURCHASER FROM ISSUER ³WITH A VIEW´ TO DISTRIBUTE A second category of underwriter. The Court held that these activities constituted ³transactions by an underwriter´ and because the bonds were not registered. were subject to regulation. Investment banker in a ³best efforts´ offering who.2d 738) An association of Chinese Americans sought to encourage the purchase of bonds of the Republic of China through mass meetings. means any offer or sale to public investors. and personal appeals. were illegal under Section 5 of the Securities Act. newspaper ads. CHAPTER 7.g. Without a compensation or specific authorization by the Chinese government. The Court reasoned that purchasers deserved the information and protection of registration. Even if the purchase is through a private placement and then resell is through a public trading market it is considered an underwriter if purchased ³with a view´ to resell to public investors (therefore. Chinese Consolidated Benevolent Association (120 F. When does a purchaser have a ³view´ to distribute? If there is an ³investment intent. SEC v. CHAPTER 7.Such term shall not include a person whose interest is limited to a commission from an underwriter or dealer not in excess of the usual and customary distributors' or sellers' commission. either primary or secondary.1. entices investors who then purchase directly from the issuer.´ An important indication of intent is the holding period before resale. E.1. for a fee. issuers often place resale restrictions on privately placed securities).1 AGENT ³FOR ISSUER´ One category of underwriter is the person who sells or offers ³for an issuer´. E. Even though the association was not an underwriter. 54 . the association remitted subscription applications and payments to the Chinese government¶s agent in NY.
Pledges What if an investor receives securities as a pledge securing a loan. OR Noncontrolling holders of restricted securities have 3 ways to resell their securities: (a) Wait until the securities have ³come to rest´. Controlling persons dumping securities are liable as statutory underwriters. Unlike a neutral investor that would like to sell for liquidity rather than for ³informational´ reasons. It all depends if the bank that received the securities was expecting that the borrower would default.1. Sherwood (175 F. Guild Films Col.Supp.2 SECTION 4(1): TRANSACTIONS DEALER NOT INVOLVING AN ISSUER. and then resells the securities after the borrower defaults on the loan? SEC v.USA v. CHAPTER 7. The regulatory concern for such activity should be at least as great as that for public offerings by an issuer because the controlling person has presumably the same informational advantages as the issuer. The SEC revised Rule 144 in 2008 to provide for a one-year holding period for the unlimited sale of restricted securities held by a non-control person. In the end. the question of whether an investor is an underwriter should turn on whether the investor who resells is likely to be in a better informational position based on a relationship with the issuer than its buyer. CHAPTER 7.3 UNDERWRITER FOR ³CONTROL PERSON´ Considers a ³control person´ which dumps its securities into a public market.2d 485) Holding banks to be ³underwriters´ for foreclosing on securities held as collateral for loans to major shareholder. UNDERWRITER. 480) Two years is sufficient proof of investment intent to avoid underwriter status. (b) Avoid a distribution and sell in an nonpublic transaction (c) Comply with Rule 144 (SEC¶s safe harbor for secondary distributions) Controlling holders of restricted securities have 3 ways to resell as well: 55 . (279 F.
(b) ³Demand Rights´ are rights that require the issuer to register the shares when the holder wants them registered. information availability.1 RULE 144: SECONDARY DISTRIBUTIONS IN PUBLIC MARKETS Most securities professionals view Rule 144 as the exclusive means for control persons to sell into a public market without registration. Rule 144 specifies the conditions when restricted securities and control securities can be resold. Registration rights typically come in 3 varieties: (a) ³Piggyback Rights´ are rights that require the issuer to register the shares for resale the next time it files a registration statement for other shares. The holding period is extended to 12 months if the issuer was not a reporting company for the 90 days before the sale or was not current in its periodic filings.2. amount sold.(a) Claim that isolated and sporadic sales into public trading markets are not a ³distribution´ (too risky). and SEC filing. The non-affiliate is subject to a holding period of 6 months for reporting companies current in their periodic filings under the Exchange Act. (b) Avoid using an ³underwriter´ either by selling in a nonpublic transaction or by selling directly on their own without assistance (very tricky). (c) Comply with SEC Rule 144 (safest). to register the shares as part of the S-3 offering. Affiliates An affiliate who sells restricted or nonrestricted securities (as well as any person on behalf of such affiliate) is deemed not to be an underwriter provided the sale meets the conditions specified in the rule on holding period. once it is eligible to use Form S-3. CHAPTER 7. Rule 144 can be summarized as follows: 56 . and (c) ³S-3 Rights´ are rights which require the issuer. Persons holding restricted or control shares can also arrange to have the issuer register the shares (possibility covered by contract rights). Non-Affiliates A non-affiliate who sells restricted securities is deemed not to be an underwriter provided the persons was not an affiliate for the 3 months before the sale. manner of sale.
2.2 EXEMPTIONS FOR SECONDARY PRIVATE PLACEMENTS The resale of restricted securities in another private transaction is not a distribution and does not trigger underwriter status. The Holding Period is 6 months for both affiliates and non-affiliates. but resales of such control securities are always subject to Rule 144 limitations. Control Securities.2d 1328) 57 . Information: Publicly available information of issuer. There is no Holding Period for non-restricted securities held by control persons. (2) not applicable to resale of debt securities. Filing: Disclosure on Form 144 if sale is more than 5. y y y (b) Resales of Restricted Securities of Non-Reporting Companies.000 shares or more than $50. Sales Method: (1) Brokers¶ transactions after filing Form 144. Section 4(1½) Exemption The Section 4(1½) exemption is a Section 4(1) exemption in which there is no distribution under the criteria of a private placement by an issuer. Non-Affiliates can resell after 1 year without limitation. Johnson (892 F. The Holding Period is 1 year for both affiliates and non-affiliates. under Section 4(2). CHAPTER 7. Affiliates can resell after 1 year but are subject to Rule 144 limitations. Section 4(1½) exemption is a shorthand expression for a Section 4(1) exemption when offers and sales are to nonpublic investors. and after 1 year non-affiliates can resell without limitation. Debt: greater of (i) 1% or (ii) 10% of tranche of debt securities in any 3 month period.(a) Resales of Restricted Securities of Reporting Companies.000. Non-Affiliates can resell after 6 months if the issuer is current with its Exchange Act filings. (c) Resales of Non-Restricted Securities. Affiliates can resell after 6 months but are subject to: y Amount Cap: Equity: The greater of (i) 1% of outstanding equity securities or (ii) average weekly trading during the 4 calendar weeks. Ackerberg v.
or such shorter period as the SEC may specify. In addition. Issuers must either be (i) reporting companies. TRANSACTIONS BY A DEALER Transactions by a dealer (including an underwriter not participating in the distribution) shall be exempt from Section 5. the transaction was not one by an issuer. underwriter. which alter the nature of the investment held by the exchanging securities holder. Information about the issuer must be available to QIBs. or (iv) a company that has undertaken to provide current financial information. defined generally as any institutional investor with at least a $100 million securities portfolio. (C) transactions as to securities constituting unsold allotment by such dealer as a participant in the distribution of such securities. (ii) foreign issuers with an exempt ADR program in the USA. CHAPTER 7. except: (A) if made within 40 days after the offering to the public. SECTION 4(3). but rather the rule anticipates the creation of a private market in 144A Securities.3 CORPORATE REORGANIZATIONS AND RECAPITALIZATIONS CHAPTER 7. Rule 144A Rule 144A is the partial codification of the Section 4(1½) exemption. the securities cannot be traded on any US securities exchange or Nasdaq. 58 . and In the event of IPOs (non reporting issuers) 90 days. or dealer. are treated as an offer and sale under the Securities Act. The Securities Act exempts exchange offers that are made as a no pressure recapitalizations in which the issuer exchanges its own securities with current holders without paying a commission for soliciting the exchange. The rule¶s guiding condition is that resales of unregistered privately placed securities be to qualified institutional buyers (QIBs).All of the underwriter definitions require a distribution and because the private sale to sophisticated Ackerberg was not a distribution (a term the Court understood to mean a public offering). instead of 40 days [25 days]. the offering is subject to registration and the regular gun-jumping rules. If the exchange offer is made to public investors.3. (B) transactions in a security as to which a registration statement has been filed made within 40 days after the effective date (without considering any time during which a stop order is issued).1 ISSUER EXCHANGES The offer and subsequent exchange of securities. (iii) foreign governments.
3. offer to sell.3. on the basis of what is in substance a new investment decision.e. Spin-offs are considered an offer and a sale subject to the Securities Act (i. Rule 145 is designed to make available the protection provided by registration under the Securities Act to persons who are offered securities in a business combination. or sale occurs when there is submitted to security holders a plan or agreement pursuant to which such holders are required to elect. and conversion rights do not represent offers or sales ³for value´ unless they are immediately exercisable. OPTIONS. though they involve the issue of new securities to existing holders. are not treated as offers or sales ³for value´ and are thus excluded from the registration requirements. consolidations and acquisitions of assets. AND CONVERSION PRIVILEGES The SEC has held that warrants.CHAPTER 7.3 DOWNSTREAM SALES AND SPINOFFS Stock splits and stock dividends. the distribution of non-public company shares to shareholders of a publicly-owned company as dividends).4 WARRANTS. both the rights and the underlying securities must be registered when issued. whether to accept a new or different security in exchange for their existing security. Rule 145 embodies the SEC¶s determination that such transactions are subject to the registration requirements of the Act. offer for sale.2 FUNDAMENTAL CORPORATE TRANSACTIONS ± RULE 145 Rule 145 Reclassification of securities. CHAPTER 7. CHAPTER 7. mergers. The thrust of the rule is that an offer. A reclassification of securities covered by Rule 145 would be exempt from registration pursuant to section 3(a)(9) or (11) [Exchange Securities] of the Act if the conditions of either of these sections are satisfied. If the rights may be exercised immediately.3. 59 . options.
INSIDER TRADING ³Abstain or disclose´ duty No statutes defines insider trading. trading on his material. nonpublic information obtained through the insider¶s corporate position. It exploits confidential information of great value to its holder. It is unfair to those who trade without access to the same information available to insiders. Three types of persons may be involved: corporate insider (will always have a fiduciary duty). CHAPTER 10.1 CLASSIC INSIDER TRADING Insider trading arises when a corporate insider trades (buys or sells) shares of his company using material (³substantial likelihood´ test). (c) Cost of Capital. (b) Market Integrity.1. and tippees (will have fiduciary duty if the tipper breached its fiduciary duty to tell the tippee (the tippee should reasonable know) and the tipper benefits or has a personal gain). It leads investors to discount the stock prices of companies where insider trading is permitted. In markets outside the US. making investors leery of putting their money into a market in which they can be exploited. studies show that cost of equity decreases when the market introduces and enforces insider trading prohibitions. thus making it more expensive for these companies to raise capital.2 MISAPPROPRIATION OF INFORMATION ± OUTSIDER TRADING ³Outsider Trading´ If the insider learns that his company will do something that affects the value of another company¶s stock. 60 .X.1.3 THEORIES FOR REGULATION OF INSIDER TRADING (a) Fairness. It undermines the integrity of stock trading markets. INTRODUCTION TO INSIDER TRADING CHAPTER 10. (d) Property. nonpublic information can also be profitable. CHAPTER 10.1. CHAPTER 10. and its regulation remains largely a matter of federal common law.1. EQUAL ACCESS TO INFORMATION: INSIDER TRADING AND REGULATION FD CHAPTER 10. temporary insiders (treated the same way as a corporate insider).
2 RULE 10B-5 AND INSIDER TRADING Perceiving a failure by state corporate law to regulate insider trading. CHAPTER 10. to impose an ³abstain or disclose´ duty to everyone with material. If the exchanges see something suspicious.Policing Insider Trading When unusual trading patterns show up or trading occurs before major corporate announcements. federal courts have used Rule 10b-5 to develop a theory of disclosure-based regulation that assumes that existence of fiduciary duties of confidentiality.2. Texas Gulf Sulphur (401 F. nonpublic information has a duty to disclose the information (or abstain from trading) if the person obtains the information in a relation of trust or confidence ± normally a fiduciary relation. the Court has held that any person in the possession of material.1 DUTY TO ³ABSTAIN OR DISCLOSE´ No person may misrepresent or silence material facts that are likely to affect others¶ trading decisions. they turn it to the SEC. CHAPTER 10. exchange officials can ask brokerage firms to turn over records of who traded at any given time.2d 833) Federal courts have held that anyone in possession of material inside information must either abstain from trading or disclose to the investing public ± a duty to ³abstain or disclose´ However. The exchanges have an Automated Search and Match System. The Supreme Court has extended this duty-based regulation to trading by outsiders who breach a duty of confidentiality to the source of the information ± even though the source is unrelated to the company in whose securities they trade (µtipping¶) 61 .would significantly reduce trading in the stock market. nonpublic information ±however obtained. Parity of Information SEC v. Duty of Confidentiality Rule 10b-5 as an antifraud rule.
SEC Dirks was a securities analyst whose job was to follow the insurance industry. O¶Hagan ³deceived´ the source that entrusted him the material. The Court took the view that a breach occurs when the insider gains some direct or indirect personal gain or a reputational benefit that can be cashed in later. The Supreme Court reversed and validated the misappropriation theory. Dirks v. Using his access to confidential takeover documents. he figured out the identity of certain takeover targets. The Court of Appeals reversed his criminal conviction on the ground that misappropriation did not violate Rule 10b-5. there had to be a fiduciary breach. nonpublic information. When he learned of an insurance company¶s massive fraud from Secrist. the Court held. Chiarella then bought stock in the targets. 62 . For Secrist to have tipped improperly. O¶Hagan trading operated as a fraud on the source in connection with securities trading ± a violation of Rule 10b-5. He purchased common stock and call options on the target¶s stock before the bid was announced. could not trigger a duty to disclose or abstain. not when the fiduciary gains the confidential information. Second. a former company insider. United States Chiarella was employed in the composing room of a financial printer. the fiduciary¶s fraud is consummated. United States v. The Supreme Court held that Dirks did not violate Rule 10b-5 because Secrist¶s reasons for revealing the scandal to Dirks were not to obtain an advantage for himself.Chiarella v. O¶Hagan O¶Hagan was a partner in a law firm retained by a third-party bidder planning a tender offer. First. The Court concluded that the unauthorized use of confidential information is (i) the use of ³deceptive device´ under Section 10(b). nonpublic information by not disclosing his evil intentions ± a violation of a duty of confidentiality. The clients dumped their holdings before the scandal became public. The Court held that merely trading on the basis of material. but when he uses the information to purchase or sell securities. The Supreme Court reversed Chiarella¶s criminal conviction under Rule 10b-5 and held that it did not impose ³parity of information´ requirement. contrary to explicit advisories by his employer. Chiarella had no duty to the shareholders with whom he traded because he had no fiduciary relationship to the target companies or their shareholders. Dirks passed on the information to the firm¶s clients. and (ii) ³in connection with´ securities trading.
to information intended to be available only for a corporate purpose and not for the personal benefit of anyone¶ may not take µadvantage of such information knowing it is unavailable to those with whom he is dealing. must abstain from trading in or recommending (µtipping¶) the securities concerned while such inside information remains undisclosed. A person trades ³on the basis´ of material. Levinson). The person must demonstrate: (a) He had entered into the plan when unaware of inside information. Anyone who. trading for his own account in the securities of a corporation has µaccess.¶ Anyone in possession of material inside information must either disclose it to the investing public. A person who sets up specific securities trading plan when unaware of inside information can avoid liability even if trading under the plan occurs later when they are aware of inside information. v. or (iii) 63 . Texas Gulf Sulphur (401 F. Insiders must wait 24 to 48 hours after information is publicly disclosed to give it time to be disseminated through wire services or publication in the financial press. Certain geologists found an extremely rare and mineral productive drilling site on November 1963. nonpublic information if the trader is ³aware´ of the information when making the purchase or sale. or. or he chooses not to do so. From November 1963 to March 1964 certain of the individual defendants said to have received µtips' from the geologists and thus purchased TGS stock and calls thereon. Materiality will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity (Basic Inc. price. State of Mind Rule 10b5-1.2d 833) Action against Texas Gulf Sulphur Company and 13 individuals alleging violations of the provisions of Section 10(b) and Rule 10b-5.Satisfying the Disclosure Duty SEC v. if he is disabled from disclosing it in order to protect a corporate confidence. A fiduciary may trade on confidential information by first disclosing the information to the person to whom he owns the fiduciary duty. Pre-Existing Trading Plans Rule 10b5-1(c). (b) The pre-existing trading strategy either (i) expressly specified the amount. and the date of trade: or (ii) included a written formula for determining these inputs. directly or indirectly.
indirectly. (f) Traders in Derivative Securities. to the issuer of a security or its shareholders of that issuer. Persons who are retained temporarily by the company in whose securities they trade (accountants. (d) Tippers. officers. Persons without a confidentiality duty. Persons with no relationship to the issuer. when aware of material. nonpublic information obtained in a relationship of trust or confidence. Lower courts have included family settings where there are expectations of confidentiality. (g) Strangers. and (ii) the entity had policies and procedures to avoid insider trading. An entity has an additional affirmative defense if (i) the actual individual trading for the entity was unaware of inside information. (a) Insiders. A person with no relationship to the source of material. There might be subtippees as well. (e) Tippees. The tip is improper if the tipper expects the tippee will trade and anticipates reciprocal benefits (return the favor). or to any person who is the source of the material. (b) Constructive (or temporary) insiders. The 10b-5 duty extends to traders in derivative instruments (call options). or derivatively. but knowingly trade on improper tips. (c) The trade accorded with the pre-existing strategy. Persons with a corporate position (directors. directly.disabled the person from influencing the trades. Persons who tip are liable as participants in illegal insider trading. employees.2.2 INSIDER TRADING RULES The breach of a duty of trust or confidence occurs when it is owed. He is liable if he knows (or has reason to know) that information came from a person who breached a confidentiality duty. or controlling shareholders) have the clearest duty. CHAPTER 10. lawyers. nonpublic information ± whether from an insider or outsider ± have no duty to disclose or abstain under Rule 10b-5. providing the actual trader was unaware of the inside information. nonpublic information. and investment bankers). The breach is deemed a deception that occurs ³in connection with´ his securities trading. (c) Outsiders (with duty to source of information). 64 .
trading by anybody (other than the bidder) who has material. (c) The communicator of the information was a spouse. nonpublic information about unannounced tender offers. Rule 14e-3 prohibits. nonpublic information about the offer that he knows (or has reason to know) was obtained from either the bidder or the target. child. during the course of a tender offer. it is less clear in other business and personal settings. A recipient of material. nonpublic information is deemed to owe a duty of trust or confidence to the source when: (a) The recipient agreed to maintain the information in confidence. unless the recipient can show that there was no reasonable expectation of confidentiality (based on the family relationship). and thereby violates § 10(b) of Securities Exchange Act and Rule 10b-5.CHAPTER 10. when he misappropriates confidential information for securities trading purposes. different from Rule 10b-5. parent. however. Misappropriation Theory There can be no 10b-5 trading liability if there is no breach of trust or confidence. Rule 10b5-2(b). Misappropriation theory holds that person commits fraud "in connection with" securities transaction. or sibling of the recipient. A 65 . Under Rule 14e-3. even if the source is a complete stranger to the traded securities.3 OUTSIDER TRADING ± MISAPPROPRIATION LIABILITY Liability arises when a person trades on confidential information in breach of a duty owed to the source of the information. there is no need to prove that a tipper breached a fiduciary duty for personal benefit. The question is who has such duties of trust or confidence and when a duty of confidentiality attaches. Rule 14e-3 ± Misappropriation of Tender Offer Information SEC prohibits trading based on material. accountant.2. Duty of Confidentiality in Misappropriation Cases The breach of duty is clear on established business relationships (lawyer. in breach of duty owed to source of information. etc). (b) The persons involved have a history. pattern or practice of sharing confidences so the recipient had reason to know the communicator expected confidentiality.
Civil Penalties The SEC can also seek judicially imposed civil penalty against those who violate Rule 10b-5 or Rule 14e-3 of up to 3 times the profits realized (or losses avoided) by their insider trading. thus recovery should be equal to the traders¶ ³losses´ ± typically significantly greater than the insiders¶ gain.4 REMEDIES FOR INSIDER TRADING Insider traders are subject to sanctions and liabilities. Mail and Wire Fraud ± Criminal Liability for Misappropriation Misappropriation of confidential information can also be the basis of non-securities criminal liability. A ³defrauded´ company may recover if it suffered trading losses or was forced to pay a higher price in a transaction because the insiders¶ trading artificially raised the stock price. SEC Enforcement Action The SEC can bring a judicial enforcement action seeking a Court order that enjoins the inside trader or tippee from further insider trading (if likely to recur) and that compels the disgorgement of any trading profits.tippee may be convicted under Rule 14e-3. even if he has no duty of trust or confidence to the source. 66 . Civil Recovery by ³Defrauded´ Source of Confidential Information Owners of confidential information who purchase or sell securities can bring a private action under Rule 10b-5 against insider traders and tippees who adversely affect their trading prices.2. Civil Liability to Contemporaneous Traders Insider trading is unfair to contemporaneous traders. Recovery is based on the disgorgement of the insider¶s actual profits or losses avoided. Insider Trading and Securities Fraud Enforcement Act of 1988 limits recovery to traders (shareholders or investors) whose trades were contemporaneous with the insider¶s. CHAPTER 10.
partners. nonpublic information to specified market professionals. (b) Disclosure to media or government officials (newspaper). 67 . When the issuer discovers it has made an ³unintentional´ selective disclosure.2. When the disclosure is ³intentional´ issuers must disclose inside information to the investing public. etc). Disclosure practices such as giving detailed financial projections to selected securities analysts or reviewing analyst reports before public release. simultaneously with any disclosure to selected analysts or investors. Controlling persons are subject to additional penalties if it knowingly or recklessly disregards the likelihood of insider trading by persons under its control.³Watchdog´ Penalties The SEC can seek civil penalties against employers and other who ³control´ insider traders and tippers. Rule 100 (a)(1). Rule 100(b). nonpublic information.5 REGULATION FD (FAIR DISCLOSURE) AND SELECTIVE DISCLOSURE Regulation FD forbids public companies from selectively disclosing material. Criminal Sanctions The SEC can refer cases to the US Department of Justice for criminal prosecution of those who engage in willful insider trading. ³Equal Access´ rules of Regulation FD have some exclusions: (a) Disclosure occurring in the normal course of business when the recipient owes the company a duty of trust (to advisers. the issuer must disclose the information to the public promptly (generally within 24 hours). CHAPTER 10. as well as security holders who it is ³reasonable foreseeable´ will trade on the basis of the information. are regulated. (d) Disclosure by foreign private issuers. Rule 100 (a)(2). ³Bounty´ Rewards The SEC can pay bounties to anyone who provides information leading to civil penalties. (c) Disclosure made in offerings registered under the Securities Act. Regulation FD applies to issuer disclosures of material.
Regulation FD is enforceable by the SEC only. through Internet or by filing a Form 8-K.Rule 101. Disclosure must be made broadly. 68 . Rule 102.
a reasonable person would attach importance to it in deciding whether to enter into the transaction. that is. Not only must misinformation have induced the transaction. LIABILITY UNDER FEDERAL SECURITIES LAWS CHAPTER 6. (c) Reliance The person who seeks to recover must have actually and justifiably relied on the fraudulent misrepresentation. an invention of equity.1 COMMON LAW OF MISREPRESENTATION CHAPTER 6.1 COMMON LAW DECEIT One who intentionally makes a material misrepresentation is liable for the losses caused by the other¶s justifiable reliance. CHAPTER 6.1. (e) Damages Recovery includes (i) out-of-pocket damages (the difference between what the person received in the transaction and the purchase price). but the misinformation must have related to the cause of the loss. The tort of deceit has 5 elements. (b) Scienter The maker of the misrepresentation must have been culpable ± that is.2 EQUITABLE RESCISSION Rescission.1. and (iii) punitive damages in flagrant cases. (d) Causation The pecuniary loss of the person who seeks to recover must reasonable has been expected to result from the reliance. he either knew or believed the facts were otherwise or lacked a reasonable basis for the representation. Misrepresentation Rescission has traditionally been based on one of two types of misrepresentation: 69 .XI. all of which must be proved: (a) Misrepresentation of Material Fact The misrepresentation must be material. seeks to undo misinformed deals. (ii) consequential damages.
The liability is measured on when the investment decision was made. One known to be false or to lack a factual basis. Not to private offerings (Gustafson v. CHAPTER 9. Gustafson v Alloyd Co. One that a reasonable person would attach importance in deciding whether to enter into the transaction.: It provides no private relief for securities fraud in market trading or private offerings. Alloyd). Express Actions under the Securities Act Section 11 of the Securities Act provides investors a damages remedy against specified defendants in cases of material misinformation in the registration statement filed in a public offering. Section 11 Violation Section 12(a)(1) Section 12(a)(2) Offer or sale ³by means of prospectus or oral communication´ containing materially false or misleading statement. Future compliance or accuracy of statements does not retroactively cure Untrue statement or Violation of Section 5 (gunmisleading omission of jumping) material fact in registration statement Section 11 has a tracing requirement (easier on IPOs).(a) Material misrepresentation. (b) Fraudulent misrepresentation.1 EXPRESS FEDERAL REMEDIES FOR SECURITIES FRAUD Courts have held that the choice of action is the plaintiff¶s. Section 12(a)(2) of the Securities Act provides for rescission relief in cases of material misinformation in a public offering outside the registration statement or by statutory sellers not subject to Section 11 liability. offering nonexempt 70 . Public offering (Jurisdictional means).5 COMPARISON TO OTHER SECURITIES FRAUD REMEDIES CHAPTER 9.5. For private offerings. Coverage Registered offering Unregistered. even when the same conduct is covered by both an express private action and an implied 10b-5 action. the only federal private action is Rule 10b-5.
after reasonable investigation that the information is true (ignorance is no excuse). and (ii) for nonexpertised portion. actually and reasonably believes. directors. Statutory seller (person who solicits for personal gain). Plaintiff Purchaser of registered Purchaser of unregistered Purchaser of securities securities. Strict liability reaches persons who solicit sales and have control of the offering.the defect. no reason to believe that information is false (ignorance is an excuse). Defense: Reasonable care and no knowledge Reliance No reliance required N/A Defense: Income statement filed 12 months after offering There can be no recovery if defendant proves the Defense: Purchaser knows untruth or omission 71 . Nonexperts (i) for expertised portion. after reasonable investigation. all who signed the registration statement. The company and the persons who sign the registration statement. underwriters and any expert who consents to his opinion being used in the registration statement. Statutory seller (person who solicits for personal gain). that information is true (ignorance is no excuse). and (ii) for nonexpertised portion there is no liability. Standard of diligence: Experts (i) for expertised portion. Statute permits securities Courts to require posting of a bond to cover defendant¶s costs. actually and reasonably believes. Joint and several liability on the issuer. Defendant Culpability Due diligence defenses for N/A everybody except the issuer.
Causation Defense: Negative N/A causation if he can show how other factors besides the misinformation explain the depreciation in value or if the value of stock rises after disclosure (Ackerman v. A causal link between the information and the plaintiff¶s loss. majority shareholders. Liability is imposed on negligent misrepresentations.plaintiff knew the alleged information was false.) Defense: Loss causation. Liability in SEC Enforcement Action Imposes liability on sellers of securities (whether in a public. Liability of Control Persons. Defendants have a limited defense if they did not know (and had no reason to know) of the facts of which liability is based. Remedy Damages formula (capped Rescission or recessionary Rescission or recessionary at aggregate offering price) damages if the stock has damages been sold. Purchasers receive a ³put´ option. Persons who control any person liable under Section 11 or Section 12 are jointly and severally liable to the same extent as the controlled person (i. Limited Liability Proportional unknowing directors.e. Section 17(a). Limitations Period 1 year after discovery / 3 1 year after violation years after offering (possible 2 years / 5 years if fraud) 1 year after discovery / 3 years after offering (possible 2 years / 5 years if fraud) Section 15. Inc. liability for N/A outside N/A Limited liability on underwriters to the amount of their participation in the offering (except for managing underwriter). directors and officers). 72 . Oryx Communications. private or exempt offering).
Rule 10b-5 Violation Section 18(a) Section 9(e) Specified manipulative practices (wash sales. A corporate manager induces his corporation to enter into a disadvantageous securities transaction. Plaintiff must post a bond to cover defendant¶s attorneys¶ fees. or it remains silent when it has a duty to disclose. (ii) obtain money by means of a material misstatement or misleading omission. Section 18 of the Exchange Act provides that false or misleading statements made in filings with the SEC trigger a cause of action for investors who can prove they relied on them. Securities professionals engage in deceptive or other unprofessional conduct in connection with securities trading by or for their customers. matched orders.The section prohibits the sale of securities using jurisdictional means that (i) employ an artifice to defraud. Express Private Actions under the Exchange Act Section 9 of the Exchange Act prohibits schemes to manipulate stock prices and creates a private action for victim of stock manipulation to recover damages. (c) Corporate Disclosures. A party to securities transactions gives false or misleading information to induce the other party to enter into the transaction. or remains silent when he has a duty to disclose. subject to a defense of good faith ignorance. A corporation (without trading) issues false or misleading information to the public about its securities. (d) Insider Trading. (f) Customer-Broker Disputes. and (iii) engage in actions that operate as a fraud. Trading in securities listed on Stock Exchange Misrepresentation or False or misleading omission of material fact in statement with respect to connection with a purchase material fact in SEC filing or sale of a security Purchase securities or sale of SEC Filing Coverage 73 . false or reckless touting. Outsiders with no relationship to the corporation use confidential information about the company entrusted to them by others and trade on this information. (e) Outsider Trading. Section 10b-5 Typical Cases (a) Securities Trading. Corporate insiders either use confidential. etc). non-public information to enter into securities transactions or tip the information to other trade on the tip. (b) Corporate Trading.
directors. Section 20(a) joint and several liability on control person. Defense: Good faith and no Required knowledge of falsity participation´) (³willful Reliance Reliance required (unless Hard reliance required. Willful participant false or misleading officers.Plaintiff Purchaser or seller Birnbaum rule: If the plaintiff did not purchase securities. the goal of liability is compensation and effectively precluding punitive damages. Out-of-pocket damages Recovery cannot exceed actual damages. Suppliers/costumers are not defendants (Stoneridge). Purchaser or seller affected securities of Purchaser or seller manipulated securities of Defendant Any person who makes Company. he has no claim. in Culpability Scienter required Recklessness included. Person who makes false statements in filing. you N/A case involves duty to speak actually read the SEC or omission) filing. Loss causation: requires the ³Price affected plaintiff show that the statement´ alleged misrepresentation or omission resulted in the claimed losses to the plaintiff. Defense: In Perio Delicto The plaintiff bears substantially equal responsibility for the violation he seeks to redress. auditors. manipulative conduct statements and induces others to their detriment. PSLRA caps damages according to a formula that seeks to discount Damages reliance caused by ³Price affected´ violation by Causation Remedy by Damages sustained result of violation as 74 .
Duty of Honesty Malone v.posttransaction volatility in prices unrelated to any misinformation. representations. or (2) obtains by means of false or fraudulent pretenses. any money or property in connection with the purchase or sale of any security of a reporting company.2 STATE LAW REMEDIES State laws provide alternatives to a federal 10b-5 action. 75 . potentially broader than Rule 10b-5. 2 years after discovery / 5 2 years after discovery / 5 years after violation years after violation N/A Limitations Period 2 years after discovery / 5 years after violation Criminal Securities Fraud Section 807 of Sarbanes-Oxley creates a crime for fraud in connection with trading in securities or reporting companies. Brincat (722 A.5. Section 1348 of the Federal Criminal Code provides that any person who ³knowingly´ (1) defrauds any person in connection with any security of a reporting company. ³Knowing´ violators are joint and several. or promises.2d 5) Shareholders can sue corporate managers for violating their ³duty of honesty´ if they knowingly disseminate false information that results in corporate injury or damage to individual shareholders. Limited Liability Proportional liability for N/A unknowing violators attributable to their share of responsibility. Shareholders deceived by corporate managers can claim a breach of fiduciary duty under corporate laws. Only reporting companies and ³knowingly´ violations. CHAPTER 9. State blue sky laws provide statutory remedies for fraudulent sales and (sometimes) fraudulent purchases. shall be subject to stiff fines or jail sentences.
unless omission. v McMahon (482 US 220) 76 .4 Arbitration ARBITRATION AND PRIVATE ORDERING Shearson/American Express. Inc. out-of-pocket damages price) or out-of-pocket damages. Private liability arising from fraudulent sales and fraudulent purchases. actionable silence or ³fraud on market´ No element Deception proximately caused losses or Culpability Reliance Causation Remedy Rescission (upon tender of purchase Rescission. Section 509 RUSA Violation Rule 10b-5 Purchase (or sale) ³by means´ of Purchase (or sale) ³by means´ of materially materially false or misleading statement false or misleading statement (or silence when under duty to speak) Purchaser or seller Purchaser or seller Plaintiff Defendant Purchaser or seller. Section 509(b) of the Revised Uniform Securities Act. officers. controlling person. fraudulent (or deceptive) conduct on which broker-dealers and agents who materially purchaser or seller relies aid in purchase or sale Defense ± Purchaser (or seller) did not Scienter required know or could not have known in Recklessness included exercise of reasonable care Purchaser (or seller) knows untruth or Actual an reasonable reliance.Blue Sky Laws Section 410 of the Uniform Securities Act. Primary violator ± person who engages in partners. Joint and several and right of pro-rata Joint and several and right of contribution contribution among liable persons Limited Liability Limitations Period 2 years after discovery / 5 years after 2 years after discovery / 5 years after violation violation CHAPTER 9. with contract damages but no attorneys¶ fees interest and attorneys¶ fees. employees. Fraudulent sales under provisions modeled on Section 12(a)(2) of the Securities Act.5. directors.
Contracting around 10b-5 Elements Parties can also by private agreement set the standards for judging their behavior. Due diligence varies in relation to 2 factors: (i) the director¶s access to inside company information.Claims of securities fraud can be arbitrated if the parties so agree. officers statement was untrue. Such standard refers to negligence on the parties involved in the preparation of the registration statement. even from management. The parties can specify greater protection that provided by Rule 10b-5 with representations and warranties and indemnification clauses. Importance of prudent man standard. believe that the statement was untrue and underwriters) Experts consent in the registration statement to liability under Section 11 when signing the prospectus. Cannot rely on representations of others. Elements: y y The burden is in the defendants. The defendant must not know that the fact was inaccurate. THE DUE DILIGENCE DEFENSE The Due Diligence defense is a defense to claims brought under Section 11 of the Securities Act. 77 . Experts are only liable for their expertise information. Break defendants in two categories: Expertised Disclosure Expert Reasonable Investigation and did not believe that the statement was untrue Non-Expertised Disclosure Not liable Non-Expert No reason to believe that the Reasonable Investigation and did not (directors. and (ii) the director¶s position as a company insider or as a nonemployee outsider. despite provisions of the Exchange Act that give federal courts exclusive jurisdiction over claims arising under the Act.
RULE 176 REASONABLE INVESTIGATION In determining whether or not the conduct of a person constitutes a reasonable investigation or a reasonable ground for belief meeting the standard set forth in section 11(c). (d) The office held when the person is an officer. BarChris would charge clients a small down payment and later would collect notes for payment installments. employees. the particular person had any responsibility for the fact or document at the time of the filing from which it was incorporated. the type of underwriting arrangement. at a discounted price. and BarChris would guarantee a percentage of payment under the notes (25% at the beginning but 100% at the end). (c) The type of person. with respect to a fact or document incorporated by reference. and (h) Whether. (e) The presence or absence of another relationship to the issuer when the person is a director or proposed director. Plaintiffs claim that the registration statement contained material false statements and material omissions. therefore it offered the convertible debentures for liquidity. (g) When the person is an underwriter. ESCOTT V. This action was brought under Section 11 of the Securities Act by purchasers of 5. (b) The type of security.. relevant circumstances include. (f) Reasonable reliance on officers. (a) The type of issuer. By 1961. and others whose duties should have given them knowledge of the particular facts (in the light of the functions and responsibilities of the particular person with respect to the issuer and the filing). 78 . BarChris needed cash. with respect to a person other than the issuer.5% of convertible subordinated fifteen years debentures of BarChris Construction Corporation (bowling lanes constructor). Facts. the role of the particular person as an underwriter and the availability of information with respect to the registrant. They would then sell the notes to a factor named James Talcott Inc. BARCHRIS CONSTRUCTION CORP.
among others (1) exaggerated 1960 sales figures in audited financial statements due to inclusion of sales of completed alleys not yet in fact sold (and now operated by BarChris¶s subsidiaries). he knew all the relevant facts. CEO had no due diligence defense since he was familiar with the business and was directly involved in negotiating with the factor. Underwriters had no diligence defense since they relied on management and in-house counsel without carrying a due diligence. He drafted the registration statement but did not carry out a thorough investigation. They had no due diligence defense since they prepared the financial information in the registration statement. Inside directors had no due diligence defense since. Holdings / Rule of Law Outside counsel for the issuer and the underwriter are not to be considered experts within the meaning of Section 11 of the Act. The Auditor didn¶t follow professional or even internal auditing standards 79 . pleaded the Due Diligence Defense. Outside Director (outside lawyer) had no due diligence defense as a Director. they knew of the financings in their favor and besides. he knew all the relevant facts omitted and misrepresented. If they may escape the responsibility by taking at face value representations made to them by the company¶s management. (2) misrepresentation that BarChris guaranteed 25% of the notes transferred to the factor when in fact it guaranteed 100%. In-house counsel which was a Director had no diligence defense except for the 1960¶s figures since it was not his expertise. as the issuer. He read. therefore. Auditor is an expert and is liable only for the expertise disclosure. He was a non-expert and was liable for expert and non-expertised information. there has to be no prove that they actually read the prospectus since by signing it. The CFO had no due diligence defense since. then the inclusion of underwriters among those liable under Section 11 affords the investors no additional protection. understood and signed the prospectus. (4) misrepresentation regarding the use of proceeds. as the CEO. except BarChris to whom. it gives sufficient proof that it was read and understood. as the CEO. Outside Director had no due diligence defense since he signed the prospectus without reading it. All defendants.The Court found materially errors in the registration. (3) misrepresentation that all loans by corporate officers to BarChris had been paid. A lawyer is entitled to rely on the statements of his client and that to require him to verify their accuracy would set an unreasonably high standard. this defense is not available.
IN RE WORLDCOM. a telecommunications giant. WorldCom announced a massive restatement of its financials on June 25. the company estimated that it would have reported a net loss for 2001 and the first quarter of 2002. but to conduct a reasonable investigation. it filed for bankruptcy. On July 21. 2002. The underwriter was also a bank and had lent money to WorldCom. It reported its intention to restate its financial statements for 2001 and the first quarter of 2002. Comfort letters include a negative assurance representation which states that there were no reasons to believe that the unaudited financial statements were not prepared in accordance with GAAP. Without the improper transfers. It is undisputed that WorldCom executives engaged in a secretive scheme to manipulate the company¶s public filings concerning its financial condition. it was determined that certain transfers from line cost expenses to capital accounts during this period were not made in accordance with generally accepted accounting principles (GAAP). The comfort letter did not include such rep. investors sought to hold issuer's underwriters liable based on claims that financials incorporated in the registration statements for two bond offerings contained material misstatements and omissions. it is not determinative. They wanted the business to follow through despite the omission in the comfort letter. If their initial investigation leads them to question the accuracy of financial 80 . ³[a]s a result of an internal audit of the company's capital expenditure accounting. Holdings / Rule of Law Underwriters are not being asked to duplicate the work of auditors. INC. The comfort letter is not by law an allegation to have made a reasonable investigation. The opinion addresses issues related to an underwriter¶s due diligence obligations.8 billion. Underwriter¶s counsel caught such omission. told the underwriter and the underwriter did nothing so they would not lose the business. A comfort letter on unaudited financial statements is required under professional underwriting standards. There are questions of fact to believe that the underwriter made no reasonable investigation. Facts.´ The amount of transfers was then estimated to be over $3. SECURITIES REGULATION Securities class action arising from the collapse of issuer. According to that announcement.
then the existence of an audit or a comfort letter will not excuse the failure to follow through with a subsequent investigation of the matter. they must demand disclosure. withdraw from the underwriting process. 81 .reporting. or bear the risk of liability. and if unsatisfied. Underwriter cannot blindly rely on experts. If red flags arise from a reasonable investigation. underwriters will have to make sufficient inquiry to satisfy themselves as to the accuracy of the financial statements.
Section 21(a) Exchange Act. Once such order is issued. Cooperation at this stage is voluntary. Section 18(e) Securities Act. such as court orders barring persons or companies from the securities business). or is about to violate the Exchange Act and its rules. the SEC can issue subpoenas. the SEC can issue a formal order of investigation. The Division refers possible criminal violations to the US Department of Justice. is violating. etc). Enforce Securities Act. Determine whether to stopping registration of public offerings. periodic inspection of broker-dealers and investment advisers. 3. If an informal investigation suggests further information to be called for. public complaints.s.1 SEC INVESTIGATIONS The SEC has investigatory powers in a number of settings: 1. Whistleblowers who work with the SEC are protected against employer retaliation. compel sworn testimony and issue subpoenas for the production of documents. A witness who knowingly and willfully provides false information to the staff commits a crime.CHAPTER 12. the SEC has broad investigatory and enforcement powers. The SEC has the power to administer oaths. 82 . SEC investigations may often come public and be relevant to subsequent civil or criminal proceedings. PUBLIC ENFORCEMENT To carry out its mandate under the federal securities laws to protect investors and ensure integrity of securities markets. 2. SEC enforcement powers and remedies are broader than those in private litigation (i. CHAPTER 12. as well as rule of stock exchange. SEC investigations are triggered from many quarters: review of SEC filings. NASD. It is also a crime to knowingly destroy documents with the intention to impair an SEC investigation.e. etc.1. SEC conducts informal investigations without a formal SEC order. Section 19(b) Securities Act. seeking for damages v.1 INVESTIGATIONS: FORMAL AND INFORMAL The SEC can investigate past violations and ongoing and impending violations. Determine whether any person has violated. The SEC¶s Division of Enforcement conducts the investigations and litigates in administrative proceedings before the SEC and brings civil actions in federal court. structural remedies. CHAPTER 12. news stories.
The SEC can summarily suspend trading for up to 10 days.CHAPTER 12. Proceeding that involve and evidentiary hearing are generally conducted by an administrative judge.1 SEC ADMINISTRATIVE ENFORCEMENT POWERS The SEC has the following powers: (a) Stop Offering. who is a SEC employee who hears pre-hearing motions. CHAPTER 12. SEC Enforcement Procedures SEC administrative enforcement actions are typically initiated by an order of proceedings that specifies the charges and provides a period for the respondent to answer. as opposed to provable cause. the SEC can suspend (for up to 12 months) or revoke the registration under the Exchange Act of affected securities on a finding of non-compliance with the Exchange Act or its Rules. (b) Suspend Trading. modify or remand the ALJ¶s decision. reverse. After notice and hearing.1. Fourth and Fifth Amendment Constitutional protections protect persons. 83 . CHAPTER 12. The ALJ¶s decision is final unless either the SEC staff or the respondent seek review with the SEC. The SEC has full de novo authority to affirm. whether a security is traded over-the-counter or on a stock exchange.2 INVESTIGATIVE POWERS The SEC requires proper purpose and that the information sought is relevant to that purpose. The SEC can issue a refusal order to prevent a registration statement from becoming effective if on its face it seems to be incomplete or a stop order of an already effective registration statement. However. can be held in contempt for noncompliance with a court¶s order. in Braswell v. but a person who fails to comply and is ordered by a court to do so. and renders written decisions. evaluates testimony. United States (487 US 99). There is no administration power to enforce a subpoena. Investigations end with a report of investigation (Section 21(a) reports) stating out the considerations whether it should lead to enforcement action.2.2 ADMINISTRATIVE ENFORCEMENT The SEC has non-judicial weapons to enforce the federal securities laws by issuing administrative orders or imposing sanctions in its own proceedings. the Supreme Court held that a one-person corporation may be ordered to produce corporate records even thought those records may incriminate the sole owner.
5 STATUE OF LIMITATIONS CHAPTER 12. A disgorgement order is within the discretion of the court.5.3. The SEC can order compliance (after notice and opportunity for hearing) with its periodic and tender offer disclosure requirements or adjudicate whether the registrant¶s filings are defective. The SEC can seek disgorgement (or forfeiture) of any profits by a person who has violated the securities laws. The SEC is authorized in a cease-and-desist proceeding to bar officers and directors from serving for reporting companies.5.4 NON-SECURITIES ACTIVITIES CRIMINAL LAW APPLIED TO SECURITIES CHAPTER 12. (f) Bar Corporate Officials.3 SECURITIES ACTIVITIES CREATING CRIMINAL LIABILITY CHAPTER 12. The SEC can enforce the cease and desist order in a federal district court.2 CRIMINAL VIOLATIONS OF FEDERAL SECURITIES LAWS CHAPTER 12. CHAPTER 184.108.40.206 SENTENCING OF INDIVIDUAL AND CORPORATE OFFENDERS CHAPTER 12.3 EFFECT OF INJUNCTION CHAPTER 12.5. (d) Compliance Order.2. if they violated Section 17(a)(1) or any prohibition of fraud in the sale of securities.6 PARALLEL ENFORCEMENT 84 . The SEC can issue (typically after notice and opportunity for hearing) an administrative order compelling any person to cease and desist from committing violation of the securities laws or their Rules.1 USE OF CRIMINAL LAW IN SECURITIES ENFORCEMENT CHAPTER 12. Before Sarbanes-Oxley. retaining an accountant to calculate the profits generated by the unlawful activity.(c) Cease and Desist Order.5 CRIMINAL ENFORCEMENT CHAPTER 12.5. the SEC was required to show the likelihood of future securities violations.5.2 DISCIPLINARY POWERS CHAPTER 12.5. (e) Order Disgorgement and Accounting.4 MODIFICATION OR DISSOLUTION OF SEC INJUNCTIONS CHAPTER 12.
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