SECURITIES REGULATION OUTLINE

Professor Haft Spring 2008 INTRODUCTION GOALS OF SECURITIES REGULATIONS Consumer Protection o Following stock market crash of 1929, Congress saw 2 main problems: Investors were vulnerable in a manipulated market The lack of confidence in markets prolonged depressions o Today, the need for consumer protection is greater b/c much higher percentage of public investment Informational Needs of Investors o B/c of the complexity of securities market, much more information is needed than in other markets o Haft says this is most important securities laws were designed to provide full and fair disclosure for investors in the marketplace Allocative Efficiency o Theory says that federal securities laws ensure accuracy of securities prices meaning stock prices conform to the fundamental value of the companies traded o Securities laws discipline poorly managed firms and rewards efficiently managed firms Corporate Governance and Agency Costs o Argue purpose of securities laws should be to reduce the SHs cost of monitoring corporate officers by mandating disclosure of the use of corporate assets by managers Economic Growth, Innovation and Access to Capital o Economies that are stock market based are allowed greater entry into the market encouraging innovation and increasing competition

THE 1933 ACT OVERVIEW Objectives Full disclosure to potential investors o Registration statement (prior to issuing securities) disclosing material facts o Prospectus (part 1 of the registration statement) most important part distributed prior to (or simultaneous with) delivery of issuers securities Prevention of fraud/misrepresentation o Accomplished through liability provisions affording defrauded purchasers more liberal remedies than those available at common law

Scope Transactions offers and sales Persons issuers, underwriters, dealers Property Interests securities Classes of Issuers Nonreporting issuers most stringent requirements (b/c they dont have to file periodic reports under 34) o b/c there is less information available in the marketplace about these issuers Unseasoned issuers o Required to file periodic reports under the 34 Act, but dont meet eligibility requirements of S-3 Seasoned issuers meet requirement for S-3 form o Reporting under 34 act for past 12 mo o Filed timely reports o Not failed to pay dividend or required payment on preferred stock o Have not defaulted on debt/rent WKSIs well known seasoned issuers (SEC has high degree of confidence in them) o Given most leeway and largest # of exceptions from regulation under 5 Regulation C, Rule 405 Must be seasoned issuers (see above), and Have either o Minimum $700MM worldwide value of common equity o Issued $1B in nonconvertible securities (cant be converted into common stock) in last 3 yrs and be issuing only nonconvertible securities o Issued $1B in nonconvertible securities in last 3 yrs, have min of $75MM worldwide value of common equity and be issuing common stock Automatic shelf registration ( the standard public offering capital raising mechanism for big corps) Process Prepare prospectus even though you have no present intention to sell securities and get the SEC to declare you effective Once effective, you do NOTHING (base registration effective for 3 years) o On the shelf where the securities remain while you have an effective shelf If at any time over the foreseeable future it turns out to be a good day to sell securities, youre effective and dont have to do anything w/respect to the SEC Ineligible Issuers include those that o Havent filed 34 Act reports in a timely manner o Blank check companies (no business specifically identified) o Shell companies o Penny stock issuers (nonlisted securities trading for less than $5/share) o Have filed for bankruptcy w/in 3 yrs o Violated securities law w/in 3 yrs o

MATERIALITY IS THERE A DUTY TO DISCLOSE? o Three types of disclosure obligations (1) Line Item Requirements Almost all mandatory disclosures refer you back to Regulation S-K RS pre-offer / Specific transactions (tenders, proxy) / Annual Obligations (10-k, etc) (2) Half-truth Doctrine Whenever you respond to a line-item requirement, you must add any additional material info necessary to make your response NOT MISLEADING o ****Rule 408(a) in addition to compelled disclosure by Commissioners line-item requirements, registrants must include in 33 Act registration statement such further material informationas may be necessary to make the required statement, in light of the circumstances not misleading (similar to 34 Acts Rule 12b-20) (3) To prevent fraud in any sale/purchase of securities Rule 10b-5 Ask whether there are some situations where nondisclosure would be fraudulent. o Efficient Market Hypothesis Disclosure policies are based on idea that securities market is efficient and that the prices of securities in the market are affected by the information available w/respect to those securities. Competing Notions disclosure requirements being limited to intelligent investors VERSUS belief that basic info must be disclosed for average investors o smart money may have incentive not to trade, or may partake in strategies that are not based on info re: the issuer IS THE INFORMATION IN QUESTION MATERIAL? o Materiality Defined in Rule 405 as information which there is a substantial likelihood that a reasonable SH would consider it important in deciding whether to purchase a security. IS IT HISTORICAL? Historic Information Determination See TCS v. Norway (1976) Defines materiality and substantial likelihood test in the context of a proxy statement (see above) IS IT SPECULATIVE? Speculative Information Determination Basic v. Levinson (1988)Adopted substantial likelihood in Rule 10b-5 context o When uncertain as to whether an event will or will not occur, the Supreme Ct adopted a balancing test o PROBABILITY x MAGNITUDE test (J. Friendly, 2nd Cir.) Probability that the event will happen (issue quantifying probability) Magnitude of effect if it does happen (issue assessing magnitude) Note OBJECTIVE STANDARD only applies to reasonable investor (not subjective)

Total Mix of Information and Market Efficiency TSC v. Norway (J. Marshall, see above) Supreme Court stated that a fact is material if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by a reasonable investor as having significantly altered the total mix of info made available in the marketplace Demonstrated through price movements that reflect consensus of investors about the importance of the information Strong evidence favoring materiality

Note Merely Finding Information Material Does NOT Mean the Company Has a Duty To Disclose It Company could keep quiet even if its material if theres no duty to disclose under BJR o What company can NOT do is LIE SCOTUS (in Basic v. Levinson) says you cant lie even to protect the business JUST SAY NO COMMENT

Section 11(c) reasonable investigation what a reasonably prudent person would do in managing his/her own affairs o Application to Defendants CEO / CFO those who know the whole truth cannot sustain this defense Directors relying on other directors is not RI (cannot claim ignorance) Applies for both outside and new directors o But outside directors have 11(f)(2) comparative fault test covered under 21D-(f) of the 34 Act proportionate liability Outside Counsel (Note Under BarChris, lawyers were not sued in their capacity as lawyers but rather as directors 11 is very protective of lawyers) Steps taken did some updating of the RS with info gathered from interviews/ claims he asked people most likely to know & should not be held liable for their lies o Court you dont have to audit company, but must verify that info is true o Reasoning 11 is about trying to create real diligence Think about conception of 33 Act initially Companies often conceal truth, and managers are therefore under great pressure to hide bad stuff If you simply take what they say at face value, cant call that a reasonable investigation o Should look at written records (K) / examine issuers facilities, operations, material K, corporate minutes, comprehensive questionnaire for director/officers, have accountant check suspicious items Underwriters (nonexperts) ct reserves special condemnation for UW Their job is to know business very well and they are the gatekeepers (meaning unless a transaction is underwritten, the offering will not succeed) o Rule 176 (est. 1981) what circumstances may bear upon determination of what constitutes a reasonable investigation and reasonable ground for belief in Section 11(b) Intent to maintain high standards for underwriter due diligence Acknowledges that different investigatory methods would be needed in view of compressed time and volatile nature of capital markets Discussed further in In re Worldcom (SDNY 2004) J. Cote stating concern that UW dont have time to do research necessary for due diligence w/the SECs integrated disclosure system & fast paced market

ANOTHER DEFENSE Statute of Limitations has run Section 13 o SoL is 1 yr after discovery of false statement o Overall SoL of 3 years after security is first bona fide offered to public Section 11(e) DAMAGES (note 11(f) is J&SL) o The difference b/w what you pay and what the security is worth at the time of judgment a recessionary measure of damages) damages are capped at public offering price (see Section 11(g)) Seems to be passed for DETERRENCE purposes rather than compensation Essentially disgorging the proceeds something that not many companies can afford!!!! o Damages Mitigation Reducing rescissory price damages accordingly Negative Causation Even if RS has # of misstatements in it, the DEF will not be liable if they prove that the stock price drop had nothing to do with the misstatement or omission. Burden on the D to show the disconnect o E.g., In re Worldcom (SDNY 2004) lawyers would be trying to show that it went into bankruptcy, but this had to do with competition, market conditions, etc rather than issues w/the RS

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Permitted dissemination of info by BROKER DEALERS & UNDERWRITERS o Section 2(a)(11) PARTICIPATION / Participates / Offers Generally, SEC allows Underwriter and Dealer to conduct normal business operations as long as they dont interfere w/objectives of the 33 Act o Publications or Distributions of Research Reports (R. 405 written communication) by B-D Rule 138 Safe harbor Issuers other securities (not those that they are distributing) Broker-Dealers may publish and distribute information regarding: (a)(1)(i) Issuers common stock, debt securities, or convertible preferred stock, if the offering is of ONLY nonconvertible debt or nonconvertible, nonparticipating preferred stock (a)(1)(ii) Issuers convertible debt securities or nonconvertible, nonparticipating preferred stock, if the offering is of ONLY common stock (3) Types of securities in question in the regular course of its business Rule 139 Safe harbor Participants B-D may publish/distribute info regarding the issuers industry or sub industry IF: Issuer has either filed an S-3 form (meaning well-seasoned or WKSI), and As of the date of reliance on this section, has filed all periodic reports required during past 12 mo on Forms 10K, 10Q, etc

Rule 137 Safe harbor Nonparticipants Relaxes rule for these folks (a) Brokers/dealers NOT participating in the offering May publish or distribute report w/in regular course of business of recommendations, information, and opinions regarding securities of an issuer (that will be filed under 13 and 15(d) of the 34 Act) BUT 137(b) If B-D receives compensation by (1) the issuer of securities; (2) a seller security holder, (3) participant in distribution of securities that will be subject of the RS; (4) any person interested in security that will be the subject of the RSthey lose this safe harbor

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EXCEPTIONS TO THE 172 no need to deliver EXCEPTION Section 4(3) 5 doesnt apply to dealers, EXCEPT dealers have to deliver 10(a) prospectus o Issuer subject to prospectus requirements so long as it is offering any security to the public. o o UW subject to 5 as long as they participate in offering sell their allotted shares Dealer subject to 5 for those transactions taking place during period of time in which distribution is presumed to occur Section 4(3)(C) any dealer participating in distribution is subject to prospectus requirements so long as they are selling unlimited allotment. (NO EXCEPTIONS) If IPO (i.e. issuer has not previously sold securities to public so not reporting company) dealer subject to 5 beginning on effective date of RS or commencement of public offering, whichever is later PLUS 90 days. o If NOT IPO 4(3)(B) time period is shortened from 90 days to 40 days. Listed Securities (listed on securities or exchange or NASDAQ) then time period is shortened further to 25 days. Rule 173 Notice of Registration (UWs/Dealers) In sale where there is not exclusion or exemption from requirement to deliver final prosp pursuant to 4(3) or Rule 174, UW / Dealer selling shall provide each purchaser with Copy of final prospectus, OR Notice that sale was made pursuant to RS or transaction which FP would have been delivered absent Rule 172 no later than 2 business days following sale Note if delivery of prosp is excused by 4(3) or 174, no notice of RS is required

Rule 174 Delivery of Prospectus by Dealers Obligation of dealer to deliver prospectus after the effective date of the RS shall be subject to the following (b) 34 Act reporting co no prosp need be delivered if issuer is subject to reporting requirements of 34 Act (immediately b4) o E.g. time period down to 0 (c) IPO no prosp need be delivered if not an IPO (d) Listed Securities (listed on securities or exchange or NASDAQ) no need to deliver prosp 25 days after initial offering date

4(4) 5 does not apply to dealers in the aftermarket (includes UW no longer acting as UW) 5 does NOT apply to dealers when doing customer orders/buy/exchange on OTC market (note does not apply when doing solicitation offers)

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And then only offer/sell securities once SEC has signed off on it. Deliver documents w/each offer Note if you do this, you dont have to register with the SEC Secondary Offerings Available for SO (e.g. sales by existing securities holders up to $1.5MM (Rule 251(b)). Sales by affiliates are not permitted if the issuer has not had net income from continuing business operations in at least one of its last two fiscal years. Sales by existing securities holders may operate to reduce the max amts applicable to issuer sales under Reg A. o E.g., if existing securities holders are selling $1.5MM in securities under the exemption, the issuer can sell no more than $3.5MM Resales (unlike Reg D, Rules 502(d) which contains restrictions on resales) May be resold immediately Rule 251(c) proves that Reg A offerings will not be integrated with either: o Any prior offerings or o Later offerings that are registered, made in reliance on Reg S, or made more than 6 mo after the Reg A offering Rule 251(c) is important in that it offers two-sided integration protection (rather than the 1-sided protection afforded in safe harbors such as Reg D) o E.g., assume 2 offerings, separated by 7 mo. The first is a 3(a)(11) intrastate exemption, and the second is under Rule 505 of Reg D. Reg Ds safe harbor operates to protect only the Rule 505 offering from earlier sales under 3(a)(11), but does nothing to protect the offering from effects of later sales under 505. Rule 251(c) of Reg A, on the other hand, offers two-sided protection that is, if the second offering is under REg A, not only will it be protected from integration w/earlier 3(a)(11) offering, but also the earlier offers and sales will be protected from integration with the later Reg A offering.

Same Bad Boy Disqualifier as Reg D Rule 262(a) If the issuer, its predecessors, or any affiliated issuer has engaged in prohibited conduct w/in the last 5 years (e.g. convicted of a crime involving sale of securities), or has been the subject within that time of certain SEC orders (such as stop order issued in connection with filing RS), the Reg A exemption is NOT available Rule 262(b) Control persons and promoters of issuers have same prohibitions except its if they were convicted of a securities related offense w/in previous 10 years Rule 262(b)(c) Underwriters are subject to same restrictions. But ALSO if they have been named in a previous SEC action, the Reg A exemption is NOT available.

Substantial Compliance Doctrine (similar to Reg D) o Rule 260 failure to comply w/a requirement of Reg A will not result in loss of the exemption if the issuer acted in good faith, the deviation was insignificant in relation to the offering as a whole, and the requirement not observed was not intended to protect the purchaser complaining of the deviation. Reg A ADVANTAGES AND DISADVANTAGES o Advantages Disclosure standards are easier to meet in a Reg A filing than in a registered offering E.g. audited financials are not required unless previously prepared for other purposes Staff review of a Form 1-A filing under Reg A is more patient & flexible than regular offering

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Significant Portions of Securities Any person who purchased significant portion of securities offered in a registered public offering and then resells then w/out registering is an underwriter C.f. Rule 144 (below) seller will not be charged w/being underwriter if re-sales are in limited quantities

(2) Individuals who purchase from issuer With a View Towards Public Distribution Catches everyone in 4(2) Private Placement and Regulation D purchased in a private placement and resells in a public trading market w/a view to resell to public (distribute) BUT purchasers unaffiliated with issuer or any principal UW who enter into agreement w/one of the principal UW to purchase all or a portion of securities unsold after a specific time are excluded from definition of UW

View towards distribution v. investment intent HOLDING PERIOD o Holding period of 2 yrs establishes presumption of investment intent o After 2 yrs, he/she can sell b/c ordinary trading transaction BUT control persons cannot sell w/out registration b/c of their status offense o U.S. v. Sherwood Investment intent is established if shares have been held for 3 years / presumption in favor of investment intent if held for more than 2 years If held <2 years, to negate intent to distribute, purchasers intent shown by: Purchasers circumstances at time of purchase, and Change in circumstances of INVESTOR (SEC v. Gilligan) after purchase giving rise to purchasers change of intent o e.g., health problem ok (sudden heart attack and wants to sell, unless its foreseeable) o cf. stock takes turn for worst NOT ok On the other hand, if shares have been held for more than two years, but less than 3, these two factors should not support and inference of an intent to distribute

(3) Underwriters WHO ARE CONTROL PERSONS OF THE ISSUER Three significant CONTROL relationships Any person controlling the issuer Any person controlled by the issuer Any person under common control with the issuer Rule 405 Defines Control Persons Someone having power to direct mgmt and policies of the issuer (through stock ownership, position in management, influence in mgmt, etc) o E.g., owning 25% common stock and sitting on BOD = control person o No need to actively participate just need the power to control Reason for regulating control persons distributions o When redistribution of a controlling amt of securities reaches large amt, the public offering may possess the dangers of a new offering of securities. o Controlling person has presumably the same informational advantage as the issuer and will be in a position of controlling the issuer, so the distributor is treated as equivalent to the original issuer and becomes subject to the act. Control is broadly defined to permit Act to apply wherever facts exist Control person may have greater incentive to exploit info advantages.

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o o o

4(2) standard private offering exemption is available only for issuer 4(1 ) has become the standard that the SEC has required for such a transaction b/c they resemble in some respects the requirements of 4(2) (issuers private placement exemption) and result in the transactions being exempt under 4(1) (transaction not involving an issuer, underwriter, or dealer) If meet policies of 4(2) private resale by controlling person (not transaction by issuer/underwriter/dealer and therefore not a distribution) to sophisticated buyer, then going to recognize the exemption

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RULE 145 extends registration reach of 5 to business combinations (unless exemption applies)
RULE 145 extended registration reach of 5 when securities are issued in connection with business combinations (mergers/consolidations/acquisitions of assets) unless there is an exemption Provisions Rule 145 provides that securities issued in certain corporate reorgs, previously exempted from 5 by rule 133, must be covered and that transfer limitations must be placed on stock received by certain SH of acquired or recapitalized corp. o Transactions covered General - proposals for certain business transactions that require the approval of SH of selling corporation are OFFERS and that consummation of transfers are SALES Reclassifications any reclassification of securities other than stock split/reverse split, or change in par value, that involves the substitution/exchange of one security of another is subject to Rule 145 Mergers or Consolidations Rule 145 applies to statutory merger, consolidation, or similar acquisition of one corp by another in which shares of A stock become exchanged for B (unless the sole purpose of the transaction was change in domicile) Transfer of Assets SUBJECT TO RULE 145 IF: Plan calls for dissolution of target co Plan calls for pro rata distribution of the exchanged securities The BOD of corp adopts resolutions relative to dissolution or distribution w/in 1 year after taking of such vote or consent Subsequent distribution was part of pre-existing plan for distribution Rule 145(c) UWs in Rule 145 Affiliates deemed to be engaged in distribution Compels registration of acquiring corp or to follow Rule 144 o Was eliminated last year with one exception If either the acquiring/ed companies are shell comps, the controlling persons are all put under registration form in 145(c) or 144 Control persons of the acquired corp prior to the transaction are deemed to be UW o UW status applies even though after acquisition, holder is not control person o Why? Prevent abuse that may occur when controlling person of target co tries to resell securities of acquiring corp RESALE OPTIONS for 145 Affiliates o Sell pursuant to 145(d) o Can sell in Rule 4 (1 ) transaction b/c 145(c) only applies to public resale o Noncontrol persons of acquired are not UW and therefore can sell in regular market transaction pursuant to 4(1) (not issuer, UW, dealer) Limited Resales are permitted for UW Affiliates of issuer after transaction RULE 145(d)(1) resales by control persons may be made w/out further registration of the provisions of Rule 144 if the following are covered: Current public info (Rule 144(c)) Limitation on amt of securities sold (Rule 144(e)) Manner of sale (Rule 144(f)) Broker transactions (Rule 144(g)) (Note no 2-yr holding period required) Special exemption from UW status (no limit on resale) Nonaffiliates of issuer after transaction Rule 145(d)(2) provides that persons who might otherwise have been considered UW will not be so if the following are met: Person has held securities of acquiring comp for at least 1 year after transaction, and o Person not affiliated w/issuer (145 affiliates not control person of issuer), & o Issuer satisfied current public info requirement of 144c OR under 145(d)(3), a person o Who is not an affiliate of the issuer or has not been for at least 3 mo, AND o Who has held securities acquired in a transaction subject to Rule 145 for at least 2y yrs

Rule 145 is EXCLUSIVE as it applies to public resales of registered securities in a Rule 145 transaction Resale provisions of 145(d) are only applicable to registered secutiies acquired in Rule 145 transaction.

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Normally silence is NOT actionable under Rule 10b-5 Bank as transfer agent for SH corp has relationship of trust that compels it to speak fully about selling options (Affiliated Use) CHC corporations duty to speak when CHC deals w/SH employees (Jordan v. Duff) Listing Standards may have affirmative duty to disclose NYSE states that a listed company is expected to release quickly to public any news which might affect the market for even a moment

RELIANCE & CAUSATION must plead both b/c reliance is folded into causation Duty to Speak cases ct dispenses w/reliance if undisclosed info was material Efficient Trading Markets cases ct infer reliance from dissemination of misinfo in market RELIANCE (Transaction Causation) Generally test link b/w alleged info and Ps buy/sell decision weeds out claims where info had little/no impact on Ps decision to transact Face to face transactions @ arms length w/Affirmative Misrep non market trans o P must justifiably rely on Ds material misstatement (prove indiv reliance) Mere negligence in checking out Ds representation is insufficient If D can prove P recklessly relied on Ds statements, may bar recovery o Must show enough familiarity w/ doc or other communication to negate possibility that transaction would have gone forward the same even w/full disc Defense of Reckless Reliance o If Ps actions were in reckless reliance, D has defenses (which will bar P recovery) o E.g., D argues P unjustifiably relied on statements b/c if looked at prospectus or other docs, truth would have been clear Non-Disclosure / Omission o In non-disc cases, positive proof of reliance is NOT prereq recovery. o All that is required is that the facts withheld are MATERIAL (Affiliated Ute) Half-Truths / Omitted Info o In cases of half-truths that render statement misleading cts divided on whether or not you have to show reliance FRAUD ON THE MARKET THEORY (FOMT) o Basic v. Levinson FOMT & Presumption of Reliance when misrep Facts Merger & 3 denials after materiality question, ct faced question of whether these individual investors had to prove reliance (which would destroy class action) P claims relia on Ds statements, they sold their shares in depressed market o The Fraud on the Market Theory Theory that in open & developed securities market, the comps stock price is determined by available material info re: comp and its business. Efficient Market stock market price immediately absorbs & reflects all info P can be harmed w/out ever knowing makes class action easier No need to directly rely on misstatements - under theory that misleading statement will defraud purchasers w/out direct reliance To use FOTM theory as a basis to establish reliance/causation, the false info must have been absorbed & widely disseminated

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