SECURITIES REGULATION GOLDEN CALF

***Two-part outline with tables at the end PART I: THE SECURITIES ACT OF 1933
I. LIABILITY UNDER 11 OF THE 33 ACT A. Introduction 1. Section 11 provides that when a RS contains a material misstatement or omission, any person acquiring a security pursuant to that defective RS (unless it is proved that at the time of such acquisition he knew of such untruth or omission) may sue. 2. Persons liable under 11 include: 1) all signatories to the RS (persons who must sign the RS include the issuer, CEO, CFO, the issuers principle accountant, and a majority of the BOD); 2) all directors of the issuer; 3) all persons named as about to become a director; 4) experts hired to prepare part of the RS: accountants, lawyers, etc.; 5) every underwriter of the security; and 6) all control persons. 3. Joint and several liability. Each of the above persons are jointly and severally liable for damages with the exception of outside directors (see 21D(f) of 34 Act). B. Elements of 11 Cause of Action. 1. Material misstatement or omission a. P must demonstrate that the RS contained a material misstatement or omission at the time the SEC declared the RS effective. b. From TSC Industries v. Northway, a misstatement or omission is material if there is a substantial likelihood that a reasonable shareholder would consider it important in his decision. 2. Standing a. Generally. Any person who purchased the security pursuant to the defective RS has standing. b. Defective securities only. If an issuer already has publicly traded securities on the market prior to the issuance of the securities issued pursuant to the defective RS, P must show that he purchased the defective RS securities in order to have standing. c. Secondary purchasers have standing. P need not have purchased the defective securities directly from the issuer to have standing. A purchaser who obtained the defective securities on the open market has standing as well. Hertzberg v. Dignity Partners, Inc. (9th Cir., 1999) [pg. 482]. 3. Statute of limitations. Under 13, a 11 action must be brought within one year of when the misstatement or omission was discovered or should have been discovered through reasonable diligence. a. In no event may a 11 suit be brought more than three years after the security was first offered to the public. 4. Damages a. Rescissionary measure of damages: under 11, each purchaser is entitled to recover the difference between the price at which he purchased the defective security and its current value. i. Reduction in damages. If the issuer can show that some or of the price drop that occurred after the registered public offering had nothing to do with the fraud, damages area reduced by that amount. b. Purchase price as cap. For purposes of the damage calculation, the purchase price may not be exceed the securitys public offering price. This provision affects secondary purchasers only. c. Recovery for Ps who already sold security. Persons who sold the defective securities prior to the 11 suit may recover the difference between their purchase price and sale price. C. Defenses in 11 Suits 1. General affirmative defenses a. Any D, including the issuer, may raise the following affirmative defenses: i. The alleged false statements were actually true; ii. The misstatements were not material; iii. The plaintiff-purchaser knew of the misstatement or omission but purchased the security anyway; and iv. The statute of limitations has run.

2.

Due Diligence Defense a. Availability. Every person liable under 11 may raise a due diligence defense except the issuer. The issuer is strictly liable under 11, making the 33 Act very worrisome to companies. b. Experts v. nonexperts i. Experts (A) Include accountants, engineers, appraisers, or any other persons who have prepared materials that form the basis of some part of the RS. (B) Experts are only liable for misrepresentations in the portion of the RS that they helped prepare. (C) To avoid 11 liability, an expert must demonstrate that he has met the following test of due diligence: (1) He actually believed the statements he made were true; and (2) His belief was reasonable. (i) For an experts belief to be reasonable he must have performed up to the standards of his profession. ii. Nonexperts (A) Include signatories to the RS, directors or partners of the issuer (or those about to be named directors or partners), underwriters. (B) An attorney does not certify his work like an accountant, and is therefore a nonexpert. (C) Nonexperts reviewing statements made by experts are entitled to rely on those statements, and need not investigate them for their truthfulness. (D) Nonexperts relying on statements by other nonexperts must show that: (1) He had no reason to believe that anything in the RS was inaccurate; and (2) This belief was reasonable. (i) In order for a nonexperts belief to be reasonable he must have made a thorough investigation of the facts. (ii) As a practical matter, there is no single standard of what constitutes a reasonable investigation for the issuers officers; the higher up a person is in the issuercorporation, the more thorough an investigation he will be required to make. BarChris. c. Escott v. BarChris Construction Corp. (S.D.N.Y., 1968) [pg. 487] i. Special condemnation is reserved for underwriters, because above all other Ds, they have the knowledge and expertise to investigate, as well as the power to stand up to the issuer. ii. Officers/directors must verify what others tell them if they are going to be eligible to claim a due diligence defense. iii. The higher up a person is in the issuer-corporation, the more thorough an investigation he will be required to conduct. iv. While inside directors (those who are also managers) will be held to the highest standard of investigation, outside directors are expected to attend directors meetings, read directors minutes, read drafts of the RS before filing, and question the companys management accountants, and counsel. If the investigation turns up misstatements, the directors must personally check into the matters and require company counsel to check into them as well. v. Officers/directors/issuer may hire outside investigators (a law firm), but their liability hangs on the quality of that investigation. Underwriters typically hire their own counsel to do a parallel investigation.

II. THE PUBLIC OFFERING PROCESS AND 5 OF THE 33 ACT A. Introduction 1. 5 Requirements. 5 of the 33 Act requires a company making a public offering of securities to register those securities with the SEC. 5 prescribes strict rules concerning the making of offers to sell and the actual sale of those securities. 2. Consequences of violation. 12(a)(1) provides that anyone who offers or sells securities in violation of 5 is strictly liable to his buyer for rescission.

b.

2.

3.

However, the waiting period may be accelerated by the SEC. The 20-day rule was effectively abandoned in the 60s, and effectiveness is now achieved by having the SEC accelerate the RS. c. If the SEC is not satisfied with the RS it will not accelerate it. i. The SEC will not accelerate the RS (or will move back its effective date) if it thinks there has been a material change since the filing of the PP. ii. The SEC has also announced that it will not accelerate an RS that indemnifies officers and directors from 11 liability, and it strongly discourages the indemnification of underwriters as well. d. As soon as the RS has been declared effective by the SEC the PEP commences and the securities may be immediately sold. i. Since the price of the security is not arrived at until hours before the RS is declared effective, the most common method used to execute sales of the security is an e-mail notification of the price of the securities; silence after notification is taken as ascent and the sale is executed. PEP requirements: a. A final prospectus must be delivered to each purchaser at the earliest of: 1) the sending of a confirmation notice of sale to the customer; 2) the delivery of the securities to the customer; or 3) supplemental literature sent to potential customers. i. In 2005 the access equals delivery rule was adopted, which does not require an issuer to send a purchaser the final prospectus as long as it is available on the issuers or the SECs website. b. This usually means that an investor will not receive the latest prospectus amendments until hes already purchased the stock, which is surprising given the SECs efforts at requiring issuer disclosure during the PFP. i. Thus, for practical purposes, 5 is not effective during the PEP. This is why the SEC eased its requirements during the PFP and WP, since the final product is not very useful anyway. (A) Shelf Registration. a. Shelf registration is a standard capital raising mechanism used by large companies to take advantage of market windows (i.e., favorable interest rates) for selling securities. Shelf registrations are usually sold to large financial institutions because the issuer is trying to raise large amounts of capital quickly. b. Shelf registering securities. A base prospectus and RS are prepared and declared effective by the SEC. The company is then in the PEP, despite the fact that it has no intention of selling the securities. When the company does decide that it wants to raise capital it may take down off the shelf the effective securities and sell them. c. Shelf registration requirements. i. When an issuer decides to sell shelf securities it must ensure that the prospectus and RS are up to date. The issuer may update the RS and prospectus either through a post-effective amendment, or the more common prospectus supplement. ii. A PS may be filed with the SEC up to two days after the sale of the shelf securities and the RS will be deemed accurate and complete. Before filing the PS the issuer sends a FWP to purchasers indicating the terms of the new stock. d. 11 liability for shelf registrations i. The issuer and underwriters are still liable under 11 for material misstatements and omissions in the RS of the shelf registered stock. ii. However, shelf registered stock is usually sold within a day of being taken off the shelf, leaving very little time for the issuer to conduct due diligence. iii. WorldCom Case: (A) WC, under pressure to grow fast, fudged its 10-Ks and 10-Qs and made a series of public offerings to increase its capital resources. WCs lawyers and bankers agreed that due diligence would be limited to a conference call on the take down day. (B) When the WC scandal broke, purchasers of these registered debt offerings brought suit. Underwriters argued that they were entitled to rely on Arthur Andersens audited financial statements, and furthermore, due diligence standard should be measured by how much time underwriters had. (C) The court held:

iii. Note that this resale restriction severely limits the liquidity of the stock, thus increasing the risk of the purchase. As a result, the issuer must discount the price of the securities in order to compensate investors for absorbing the increased risk. 7. Rule 508 Substantial Compliance with Reg D a. An issuer will still be allowed to claim the Reg D exemption if in good faith attempted compliance he commits an inadvertent and immaterial violation of Reg D. b. However, this defense may not be raised against persons actually prejudiced by the violation. c. Some violations are never material or inadvertent, including violation of the ban on general solicitations. D. Rule 701: Non-Public Company Employee Compensation 1. Non-public companies may use stock options as compensation for employees without registering the securities notwithstanding Ralston-Purina. Restrictions: a. $5M cap in securities issued. b. Securities issued cannot constitute more than 15% of companys assets. E. Reg A: Mini-Registration 1. Small, non-public companies, raising no more than $5M can qualify under Reg A and sell securities without registering by: a. 1) Preparing a disclosure document; 2) filing it with the SEC; 3) waiting for SEC approval before offering/selling securities; and 4) delivering the disclosure document with the securities. b. While this process looks very much like registering there is one big advantage: because this is not really registering there is no 11 liability. 2. How does Reg A differ from Rule 505? a. Disclosure must be delivered to all offerees under Reg A. b. However, under Reg A, there is no ban on general solicitation. Issuers may engage in aggressive marketing efforts. V. SECONDARY DISTRIBUTIONS A. The Underwriter Concept 1. Exempted transactions. 4(1) exempts from the requirements of 5 any transaction conducted by a person who is not an issuer, underwriter or dealer. 2. Underwriter defined. 2(a)(11) defines an underwriter as any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security [or directly or indirectly participates in such an undertaking]. a. For purposes of 2(a)(11) an issuer includes any affiliate, i.e., control person, of the company. i. This provision affects the control person himself, since, if he distributes his stock to underwriters the sale of that stock becomes an underwritten transaction losing its 4(1) exemption. The control person (and anyone else involved in an underwritten transaction), and not just the underwriter, would therefore have violated 5. U.S. v. Wolfson (2d Cir. 1968) [pg. 360]. 3. Broad scope of 2(a)(11). a. In SEC v. Chinese Consolidated Benevolent Association (2d Cir. 1941) [pg. 348], uncompensated Chinese-Americans, acting out of pure patriotism, were held to have underwritten the sale of unregistered Chinese Government bonds by encouraging other Chinese-Americans to purchase the bonds. b. In Harden v. Raffensperger (7th Cir. 1995), an investment banker retained to perform due diligence on the offering of another investment banks securities was deemed to have underwritten the transaction, as 2(a)(11) is broad enough to encompass all persons who engage in steps necessary to the distribution of securities. c. Generally, courts have interpreted 2(a)(11)s participates language to include those persons who have provided substantial assistance that facilitates the issuers distribution. While merely drafting PO documents will not give rise to underwriter status, a person who markets the securities, persuades potential purchasers, or lends credibility to the issuance is likely to be considered an underwriter. 4. Come to rest. Persons who purchased securities from an issuer will be deemed to have purchased with a view toward distributionand will therefore be considered underwritersif the securities do not come to rest in the hands of those purchasers.

10

B. Executives 1. Certification. Executives must certify every 10-K/10-Q/8-K released by the company, stating that to the best of their knowledge the report is accurate and fairly presents the companys financial situation. a. Senior officers must include in their certification a representation that they have brought to the auditors and the audit committees attention all significant deficiencies in the design and operation of internal controls which could adversely affect the registrants ability to record, process, summarize and report financial data. 2. Penalties. False certification is a federal crime punishable by imprisonment. 3. Internal controls system. A companys executives are required to set up an internal controls system providing: a) whistleblower protection; b) embedded auditors (company spies); and c) the requirements of the FCPA (above). C. Auditors 1. Problem. Enron and WorldCom were both independently audited by Arthur Andersen, yet AA did not report any of the securities violations going on in the company. This was a result of two sources: a. A lack of will: AA didnt want to blow the whistle on its major customers; and b. A lack of effort: AA did not seek disrupt its business relationships by attempting to uncover ongoing fraud in the companies. 2. Solution: Auditor Requirements a. Independence requirements. i. Non-audit services. S-Ox amends 10A to bar auditors from performing certain non-audit services to their clients in an effort to disincentivize an auditor from engaging in lax auditing in return for other business. The audit committee must approve in advance all services provided to the company by the auditor. ii. An auditor cannot: 1) audit his or her own work; 2) perform management functions in the company; or 3) act as an advocate for the client. iii. No common executives. 10A(l) bars an accounting firm from auditing the books of any company whose CEO or CFO in the past year was an employee of the accounting firm. iv. Rotation. 10A(g) requires the lead audit partner for a client to be rotated every five years. b. PCAOB. The Public Company Accounting Oversight Board, while not a federal agency, has distinct statutory responsibility and police powers. c. Reporting requirements. 10A requires auditors to report material noncompliance to the companys BOD; if the BOD does not acquiesce to the auditors suggested changes, the auditor is required to report the noncompliance to the SEC. d. Internal control system. i. Under S-Ox, a reporting companys management must create and implement a system of internal controls. ii. The companys outside auditor is responsible for auditing the control system and report on any material deficiencies in the system. This created a windfall for the auditing industry. iii. The standard of evaluation of a companys internal controls was recently amended from auditing standard #2auditors have to work to find any more-than-remote risk of inaccurate financial reporting, which requires a detailed analysis of the companyto AS #5, which requires only that auditors conduct a top-down risk based assessment rather than a thorough, down-to-the-ground investigation. D. Independent Directors and Audit Committees 1. Independent directors. Independent directors have substantially less incentive to cheat than inside directors (executive officers) because they are usually not compensated with stock options, and when they are, at a much lower level. 2. Requirement for IDs. State law does not require IDs, however IDs are required by most exchanges and marketplace demands, and encouraged by DE law, which requires IDs for deal-cleansing. 3. Audit Committee. a. Requirement. S-Ox requires that every reporting company have an AC comprised exclusively of IDs. Among the criteria for being an ID is that the director cannot receive compensation other than for directors fees. b. Responsibility. The central function of the AC is the oversight of the companys audit and financial practices.

15

3.

such price movements as evidence of materiality. Elkind v. Ligget & Myers, Inc. (2d Cir. 1980) [pg. 593]. ii. Truth on the market. In Weilgos v. Commonwealth Edison Co. (7th Cir. 1989) [pg. 594], Easterbrook used the converse of the above approach to conclude that because Comm Eds stock price did not move upon the disclosure of new information, its earlier statement did not significantly alter the total mix of information available on the market. The market had already anticipated the new information and impounded it into Comm Eds stock price prior to Comm Eds disclosure of it. d. Puffery. i. In Eisenstadt v. Centel Corp. (7th Cir. 1997), Posner concluded that information is immaterial when it is the result of pufferynonspecific representations, general expressions of satisfaction, vague language like going smoothly. Where puffing is the order of the day, literal truth can be profoundly misleading Mere sales puffery is not actionable Scienter a. In Ernst & Ernst v. Hochfelder (1976) [pg. 670], the Court held that scienter is a required element of a 10b-5 cause of action, because it is based on the common law intentional tort of fraud. b. Awareness or Recklessness. i. Awareness. Most courts hold that mere awareness of the fraud satisfies the scienter requirement, Life Insurance Co. v. Ernst & Young (2d Cir. 2000) [pg. 671], while a small minority of courts require that the defendants purpose was to defraud investors. U.S. v. Stewart (SDNY 2004) [pg. 672]. ii. Recklessness. The overwhelming majority of courts have held that recklessness also satisfies the scienter requirement. Recklessness is not simply inexcusable negligence, but must be a lesser form of intent, Sanders v. John Nuveen & Co. (7th Cir. 1977), an extreme departure from the standards of ordinary care, Broad v. Rockwell (5th Cir. 1981), or carelessness approaching indifference, Hoffman v. Estabrook (1st Cir. 1978). A) Ignorance of law is no excuse for recklessness. B) The scienter of a key executive is imputed to the corporation. c. Pleading scienter. i. Strong inference requirement. 21D(b) of the 34 Act requires plaintiffs to show a strong inference of a 10b-5 violation to satisfy FRCP 9(b). This requirement is most important with respect to the scienter element. Courts are instructed to stay all discovery pending determination of the strong inference requirement. A) The SEC takes the position that the strong inference requirement does not apply to enforcement actions brought by the SEC. ii. In Tellabs, Inc. v. Makor Issues & Rights (Ginsburg, 2007) [Courseware] the Court set forth the standard for what constitutes a strong inference: The inquiry is inherently comparative: To determine whether the plaintiff has alleged facts that give rise to the requisite strong inference of scienter, a court must consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff A complaint will survive, we hold, only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged. iii. Tellabs decided only what level of proof is required by the strong inference requirement. Lower court approaches are still important for determining how to satisfy the strong inference requirement: A) Overt facts showing fraud: 1) internal company documents evidencing scienter; 2) Ds contradictory statements or acknowledgement of a lie; 3) company insiders providing information of fraud; 4) D benefited in a concrete way from alleged fraud (evidence of insider trading); 5) D engaged in deliberately illegal behavior; 6) D failed to check information that it had a duty to monitor. B) Motive and opportunity. In Time Warner (2d Cir. 1993) [pg. 674], the court held that the strong inference requirement is satisfied even in the absence of a smoking gun, if a compelling story demonstrating Ds motive and opportunity to lie is presented. This test is accepted by some circuits, and has been expressly rejected by the 9th Cir.

20

VI. LAWYERS LIABILITY AND ETHICS A. Lawyers Obligations Under the Securities Laws 1. Rule 102(e). If a lawyer willfully violates any securities regulation (legal violation) or engages in improper professional conduct (ethical violation), the SEC, on its own motion, can seek to bar that lawyer from any further practice before the SEC. a. With regard to ethical violations, the SEC does not draw from the code of professional conduct of any state, but creates its own rules of professional conduct. b. The SEC has three basic rules of conduct (the last of which is controversial): i. Corporation as client. When a lawyer represents a corporation, the corporation alone is his client, and not its officers or directors. ii. Crime-fraud. A lawyer may not render legal assistance to a clients activities if those activities are criminal or fraudulent. iii. Confidentiality exception. Controversy surrounds whether a lawyer may, must, or is prohibited from disclosing a clients future criminal conduct if it will cause others economic injury. Some states limit the right/duty to warn to physical harm; other states and the ABA Model Rules give the lawyer the right but not the duty to warn; a few states require a lawyer to warn. 2. Commission Rules of Practice Part 205. a. Up-the-ladder reporting. i. If a lawyer becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, they lawyer must report such evidence to the issuers chief legal counsel (GC). ii. If the GC concludes that no violation is occurring and provides an adequate explanation, or acknowledges the problem and states it will be corrected, the lawyers obligation is satisfied. iii. If the GC does not provide an adequate response, the lawyer must continue up-the-ladder to the CEO, and if need be, the issuers BOD. b. Reporting out. The SEC proposed a noisy withdrawal requirement, which was never adopted because of overwhelming public outcry. c. Evidence standard. Evidence of a material violation means credible evidence, based upon which it would be unreasonable under the circumstances, for a prudent and competent attorney not to conclude that it is reasonably likely that a material violation has occurred, is ongoing, or is about to occur. d. No private right of action exists under Part 205. Authority to enforce compliance with Part 205 is vested solely in the SEC. VII. INSIDER TRADING A. Tender Offers and Insider Trading: Rule 14e-3 1. Once a substantial step toward the commencement of a tender offer has been taken, 14e-3 bars any person (other than the bidder) from acquiring any securities while in possession of material information that he knows or has reason to know: a) is nonpublic; and b) was acquired from the bidder, the target, or any person associated with either one of these. 2. No breach of fiduciary duty is required for a 14e-3 violation. 3. The requisite state of mind for a 14e-3 violation is reason to know. Since this is not 10b-5, it isnt presumed that this language means reckless. 4. Rule 14e-3 also contains an anti-tipping provision, barring the communication of material nonpublic information concerning a tender offer to persons where it is reasonably foreseeable that such communication is likely to result in unlawful trading. B. 16 Insider Trading 1. 16(a). Reporting Requirement a. Imposes a reporting obligation on officers, directors, and 10% shareholders, to file with the SEC forms that indicate holdings in the issuers stock upon achieving insider status. Thereafter, purchases or sales by the insider have to be reported by the end of the second business day following the transaction on Form 4. b. The same beneficial ownership and group standards of 13(d) apply. c. Regardless of title, 16 reaches any person that has significant policymaking involvement at the highest level of the company.

25

however, copies of the disclosure documents filed in the companys home country must be filed with the SEC. c. Applicable rules. Neither the SEC proxy regulations nor 16 apply to foreign companies. With a few exceptions, S-Ox does apply. 2. Proposal. a. Problem. i. Because U.S. securities laws are fairly intense as compared with the securities laws in the worlds other major exchangesLondon and Hong Kongdata has confirmed that international companies have slowly migrated away from conducting POs in the U.S. While improvements in technology at the other exchanges and their geographic proximity to European and Asian companies has contributed to the migration, the strictness of U.S. securities laws is believed to be a key reason. ii. The majority of foreign issuers using U.S. exchanges come from poorer countries with weak securities regulation, who use the U.S. exchanges for credibility. As the worlds securities laws improve every year, these issuers will gradually migrate elsewhere as well. iii. The future of the world economy rests with the four fastest growing capital markets: Brazil, Russia, India, and China. b. Passport System Proposal. i. The EU already uses a passport system: an issuer from any EU country may issue securities in any other EU country, provided they comply with their own countrys disclosure obligations and that countrys securities laws meet a minimum standard. ii. The US already has such an agreement with Canada, but many wish to extend this system to the EU and other countries, on the basis of reciprocity. iii. This passport system will eliminate the perception of foreign companies that U.S. securities laws are too intensenow those foreign issuers (of approved countries) will only have to comply with their home countrys disclosure obligations. iv. Further, in an efficient market, the system will work perfectly despite the fact that the issuers on U.S. exchanges will come from various countries with differing degrees of investor protection. The market will price in to the stock the risk of fraud dependent on the degree of protection offered by the issuers home countrys securities laws. On average, investors will do fine under this system. B. Subject Matter Jurisdiction 1. Even under the passport system, the U.S. would retain its anti-fraud subject matter jurisdiction, which is applied in two ways: a. Effects based jurisdiction. i. If fraud is perpetrated in a foreign country and then launched into the U.S. (e.g., via a public offering), such that the fraud injures U.S. investors, U.S. courts will exercise jurisdiction over claims by the U.S. investors against the foreign company, under the IL principle that a country is allowed to regulate conduct around the world that has direct and unambiguous effects on its citizens. ii. Bersch v. Drexel Firestone, Inc. (2d. Cir. 1975) [pg. 1143] A) A Canadian company conducted a PO, which 22 Americans participated in after prospectuses were sent into the U.S. The court stated when a U.S. court will have jurisdiction over U.S. citizens (home and abroad) and foreign citizens. The federal securities laws: 1) Apply to losses from sales of securities to Americans resident in the U.S. whether or not acts (or culpable failures to act) of material importance occurred in this country (pure effects-based jurisdiction); 2) Apply to losses from sales of securities to Americans resident abroad if, but only if, acts (or culpable failures to act) of material importance in the U.S. have significantly contributed thereto (mixed effects-conduct-based jurisdiction); 3) Do not apply to losses from sales of securities to foreigners outside the U.S. unless acts (or culpable failures to act) within the U.S. directly caused such losses (conductbased jurisdiction).

30