I.

Introduction:
a. Historical Background/Overview:
i. Labor + Capital = Wealth [all societies agree with this –capitalist, socialism etc)
ii. Formation of capital is the life-blood of business [need capital to form and grow business]
iii. Capital raising system – created by wealthy Europeans – Merchants- way to spread risk – mrchnt bank-corp.
iv. EAST – India Tea Company – take European goods to America & trade for indigenous goods
1. Risk to take journey: [natives not want it, ship not make it]–if ship returns– pay captain crew, sell indig
goods & split money left w/ equity owners (ship investors)–if ship not make it–investors lose (pick bad stk
v. First Public Issuance of securities – Civil War. Union issue bonds to support war effort – paid off w/ 3% int.
1. Merchant banks not have enough –
2. Sec of Tres. –sell war bonds to public – to raise capital to finance war [so taxes & bonds finance war]
3. Confederate also sold bonds but b/m worthless – so south capital base wiped out
vi. Industrial revolution (Rail, tele etc) – Co. need money& not enough from Merchant bankers so turn to public
there was some fraudulent schemes but only remedy was CL tort fraud – not feasible so fraud went unchecked
vii. 1920s states began to enact own securities laws (Blue-sky laws) – some success but public soon lost faith so
stock market crash;
1. After Depression - Need capital to jump start the market – need investor confidence
viii. FDR – campaign new deal – b/c knew if capital ceases- a capital system can’t function; All banks are
bankrupt no money – only source of capital is American public but have no confidence
1. First 100 Days – FDR rushed to enact the securities act of 1933 – provides full disclosure & remedies
ix. ALL SECURITIES LAWS about Disclosure – if instrument is defined as Security – get all sec laws

b. 4 Main Securities Laws – (all admin by SEC)

i. Securities Act of 1933 – a consumer protection statute, rose from ’29 crash – main purpose is to mandate
disclosure (thru registration or exemptions) to investors so can make smart informed; full fair; decisions;
1. Deals with Selling & Issuance of securities to the public – Which is raising capital;
2. Also have disclosure forced to the SEC; and if insufficient disclosure easier to get damages then CL fraud
3. Regulates primary and secondary offerings----not secondary trading/transactions
ii. Securities Exchange Act of 1934 – is a regulatory statute – by SEC – regulates exchanges, broker/dealers,
public Co., insiders, tender offers, and provides anti-fraud provisions
1. Created the SEC – incr. investor confidence; regulates how market runs & how broker/Deal run their bus
2. Regulates secondary transactions/trading (after market trading)
iii. Investment Company Act of 1940 – intended to target pre-crash abuses of investment pools – ’40 act
regulates investment companies; mandates registration & has exemptions; dictates organization and operation
rules; Regulates Mutual funds (pool investing)
iv. Investment Advisors Act of 1940 – regulates anyone who for value, gives investment advice as to the
purchase & sale of securities; Act is regulatory & notably prohibits contingent fees based on performance;
v. Blue Sky Laws – vary state by state, unlike SEC – states only merit review of offering – have a fair/just and
equitable standard
1. National Securities Market Improvement Act – prempt from state review – variety of covered securities
including those traded on Nasdaq, NYSE, AMEX

c. Terminology
i. Types of Bank
1. Merchant Bank – classical model of getting capital – an institution invests its own money in
your firm to develop your product [put your money up]
2. Commercial Bank – institution takes deposits & uses it to make investments (ie loans); eg citi
3. Investment Bank – institution that goes out & finds the money to invest in firm–[puts 2 people
together]
ii. Broker/Dealer

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 1. Broker (NYSE) – exchange market – broker puts buyer and seller together and transaction is
done; The buyer is privity to K w/ seller but it is privity w/ an anonymous person; B&S each call their
brokers to make a transaction then brokers met on floor of exchange to complete txn and trades goes on
ticker
a. Broker gets a commission for this – need be licensed to get commission
2. Dealer (NASDAQ) – OTC market – Dealer sells out of its inventory (buyer privity of K w/
dealer)
a. If sell MS, Merril – dealer – would buy it and take it as inventory and puts it on the shelf; if
someone else want to buy MS; ML takes it off shelf & sells it to them;
3. Broker Dealer – someone does both exchange and OTC market
4. NYSE quotes the last trade price; 50 is last txn btwn buyer and seller that was made thru broker
5. NASDAQ – quotes what dealer is willing to pay for the security (bid price) and what dealer is willing to
sell the security for (ask price); Bid –ask Spread /markup – Dealer – ML can make $$-constant Buy/sell
iii. DEBT – comes in three forms – each is loan to company – can be security
1. Notes – short term investment (I owe you) – promise/obligation to pay (1-4 years)
2. Debentures – Intermediate term investments (5-9 years)
3. Bonds –long term – (10-30 years) – generally secured by assets
iv. Equity – ownership interest in a company – (if stock – still need to do economic reality test to see if security)
v. Securitization – taking something not a security and turn it into a security
vi. Registration of securities vs. Reg of transactions–you register an offering not a security and not a Company
vii. Initial capital–putting money up for Co. etc; (trading on exchange not put money into Co just change hands)

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II. What Is a Security
a. Overview:
i. IF something is a security then the Fed. Securities laws apply – ’33 and ’34 act; Investors want the protection
of the securities acts and if security easier for lawsuits and remedies in securities fraud then CL tort fraud;
ii. A security is a security – not matter if public stock or closely held Co; not matter to security definition;
iii. IF instrument is a security – no offer or sell unless registration or exemption [illegal to opt out sec laws] –
sec14 of 33 act – any conditions on application of 33 act shall be void [pg 58 – policy – elective sec laws]

b. Statutory Definition of Security: [first place to start]

i. ’33 Act §2(a)(1): The term "security" means any note, stock, treasury stock, security future, bond,
debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement,
collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract,
voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other
mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or
index of securities (including any interest therein or based on the value thereof), or any put, call, straddle,
option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general,
any interest or instrument commonly known as a "security", or any certificate of interest or participation in,
temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase,
any of the foregoing.

c. Judicial Definition of Security (Investment K)

i. Investment K–should be default (catch all) definition of security–starting point of analysis; Best way to see if
instrmnt is a security is HOWEY Test; - All finan instruments & stocks start w/ Howey but not Notes (Reves)
ii. SEC v. Howey –pg 21 US 1946 – right after WWII – first attempt of court to define security; no investor
complained about Howey’s actions – people made money like Howey said, there was no ponzee etc but SEC
sues b/c says can’t offer security unless register offering; Howey says its not a security: Howey bought land
and sold strips of land with orange trees on it to the public (fee simple absolute ownership) but then Howey
gave owners the option of entering a service/mngmt K with Howey to plant trees, pesticide, harvest & sell
them as part of pool of oranges to the buyer and Howey Co. takes a certain percentage of sale for its mngmt
and money left over is given to land owners based on how much land owned;
1. Howey states only selling land and offering service K if want; SEC says created investment K
2. Buyers of land didn’t really want actual oranges they wanted return on their investment – make a profit
3. Ct held that this was an investment K and should be registered under the 33 act; Look at the
economic nature of the enterprise; substance over form; (land ownership combined w/ mngmnt K –expect
profit)
4. RULE: “investment contract for purposes of securities act means a contract, transaction or scheme
whereby a person invests his money in a common enterprise and is led to expect profits solely from the
efforts of promoters or a third party”
a. Solely was a mistake and subsequent cases read it out – b/c can just have land owner once a year
pick a orange; so now substantial efforts of others;

iii. Howey Test for investment Ks [risk is irrelevant]– A security is any contract transaction or scheme whereby:
1. A person invests money (or something of value) [investment of money]
2. in a common enterprise, and
3. where expectation of profits and success depends on efforts of others
a. (no more solely others; now predominantly or substantial—SEC v. Koscot)
4. [any instrument passing howy is a security; but if not meet howey it still maybe a security justify status as
security in some other definitional matter]

5. [marine bank later added to this – better regulatory scheme and uniqueness exception]
6. [howey test -east india tea co. had these factors – people invest $$ in common enterprise where profits
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 depend on others efforts – this is Capitalist system – capital/labor dichotomy capital is passive)

iv. HOWEY TEST APPLIED:

-Forman extend Howey Test to all securities and maybe Marine bank and Landreth cut back Howey litle
1. Investment of Money–intention is $$ given over w/ expectation of profit or return on investment
as 1˚ reason took action; if purchase for use /consumption then not an investment (passivity?) need to
INVEST;
a. United Housing Foundation v. Forman -pg29 – US 1975 – in order to buy an apt in Co-Op
City- one needed to buy X shares of stock in the management company and when sold apt you would
sell your shares back to the management company and get money back; P sued had problems and
instead of state court sues in federal ct bc says mngmt Co sold stock w/o registration – so P can get
securities fraud relief
i. HELD–This is not a security even though stock is in the definition of securities look @ whats
really going on (Economic Reality) & Consumption test & failed 1st prong of Howey(no invst

ii. Economic Reality Test – aka basic common sense test – no expectation of profit;
1. there was no investment of money, person was trying to buy an apt and any
appreciation is in the apt not the stock; invest is give $ for profit;
2. Substance over form governs(like howey) …possible challenge - Landreth
3. NOT everything called a stock is stock/Security; - term is not dispositive;
a. Here no rights of stock- non transferable, no pledge or encumber; no
voting rights;
b. “reject at outset any suggestion that the present transaction evidence by
the sale of shares called stock, must be considered a security transaction simply b/c
the statutory definition includes the words…any stock”
4. Int’l Brotherhood of Teamsters – noncontributory compulsory pension plan is not
an investment K; economic reality – EE sells labor to make living, not an investment,
and ER is the one contributing; also Pension covered by ILISA – so marine bank;
iii. USE/Consumption Test – Can’t double dip – invest money and use it as well;;
1. If give $ to get goods or services in return that they intend to use it – it is not an
investment and therefore not a security [jury question investment or consumption]
2. Foreman – bought apt to use – so no passivity so not investment ;

b. Jaguar example: pg 34 (Use/Consumption Test) – Jaguar need capital or car not get produced
(take 2yrs), Car will be worth double the price once person gets it; IF this is a security depends:
i. IF Jaguar rep goes to bank/people and says give us money and it will double in 2 years – if
want the profit and not the car – it is an investment and a security; ie not even see if owners
want the car, have licenses etc–just sell to them get capital & ownr will turn around and sell it
ii. IF Jaguar goes to list of previous customers who own high end and say want this car – give us
money now and get car if 2 years worth double the price you paid; IF person wants car not
the profit then this is use/consumption and not an investment/security;
iii. INTENTION of Jaguar [seller] matters & get Rep/Warranty from buyer that for use not profit
iv. IF security for one person – security for all;
c. SEC v. Edward – payphone franchise for prisons – structure with a fixed rate of return – This
does not violate HOWEY and it can still be a security; whether fixed or variable irrelevant to Howey
test

2. Common Enterprise (Commonality) – circuits split as to requisite commonality for Howey

(Hor/Ver)
a. HYPO: Ski Resort with 12 lodges; promoter goes to investor – if buy this lodge I will maintain
it, insure it, rent it etc; (this is a security; say if you use it once a year – not consumption?)
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 b. (1st determine circuit – Broad vertical, Strict vertical than Horizontal-least to most difficult))
c. Horizontal Commonality – (howey was this) – at least 2 investors who have similar relationship
in the business enterprise – they all pool their investments and share the profits
i. Requires an enterprise and class of investors, all of whom share equally or generally in the
success of the venture (Pooling of investors funds);
ii. Investors all rise & fall together; group of investrs all gave $ & promoter takes responsibility
iii. Lodge – if your lodge bad spot never rented – not matter b/c pool all $ from all investors and
split profits; So pool success and risks; and if one not rented – all get little less profit;
iv. Commonality btwn investors rather than investor and promoter(vertical)
v. ONE investor problem:-need 2 for horizontal commonality but POSNER in Lauer – if circuit
has horizontal com and 1 investor – not matter b/c it is character of investment vehicle that
matters, not # of investors, so if theoretically can have multiple investors then requisite
horizontal commonality is met
vi. Wals v. Fox Hills: Ps bought a timeshare for a condo at golf resort & ended up trading their
share for another work, but left their timeshare time to be rented out by the management co.
Ct. found that although there was an investment of $$, & that Ps were relying on the efforts
of the management co, the scheme failed commonality b/c the other owners were not pooling
their profits into together [fail horizontal commonality – no pooling of profits]
d. Vertical Commonality – (easier to meet b/c always have promoter & investor link unlike horiz
need many investors or possibility of many) – SO if promoter & at least 1 investor share in success or
failure of business venture– commonality is met; ---PROMOTER tells investor I will rent your lodge
[individ. Relationship] and take expenses and fees and then you get the profits; so if investor has bad
lodge screwed - no money is pooled;
i. Strict Vertical Commonality - promoter and investor linked both make and lose money
together – direct and proportionate rise and fall, both share in sucess
1. If not rent lodge – still have expenses – so here promoter and investor both pay
expenses pro rata – so both can lose money
ii. Broad Vertical Commonality –some unity of interest – but here promoter need not lose
money if investor loses; (NO Lost interest) –only some effort on part of promoter for success
1. If not rent lodge promoter not get his % of profits but still gets expenses paid by
investor – so promoter does not share in losses – ie share of expenses; but only share in
upside profits;
iii. Example–rent 1000/month; 100 dollars expenses; promoter gets 10% profit (90); 810 to
investor – STRICT vertical-if not rent lodge 100 expense still paid but promoter pays 10% of
it b/c no rent to take the expense from – so share in upside and downside; if BROAD – if not
rent – Investor pays all 100 expense & promoter pays nothing & gets nothing – bc no profit;

3. Efforts of Others:
a. Capitalism is passive investment of money to be used by others and then returned w/ profits;
b. EFFORTS OF OTHERS – refer to the party investor is dealing with – not some 3rd party
c. Solely by efforts of others has been written out of Howey; (SEC v. Koscot); the investor must
rely predominantly on efforts of others(ie substantial efforts of others) –some invest particip not ruin sec
d. Franchise – great investment – put $$ have others run but then F’OR being examined by SEC for
selling security –b/c of HOWEY change model now need OWNER-OPERATED–no passive investment
in franchise b/c F”OR (MCD) though provide support not want to be governed by securities laws
i. SO now franchises are generally not securities
e. SEC v. Life Partners – pg 43 – 1996 DC Cir – D matched investors with AIDS patients. The
patients would receive $$ today in exchange for their life insurance policy to be assigned to them; D
would receive commission to match up. CT held these were not investment Ks – there was investing of
money and pooling money (common enterprise) for expected profit but no effort of others.
i. Promoters – did work before investment but no sufficient efforts of others post investment;
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 just wait for people to die and get money – capitalist society give money and others do stuff
f. SEC v. EDWARDS – fixed income – still can be efforts of others;

v. Limitations of Howey:
1. If an instrument no matter what it is called passes howey test it is a security but if not meet
Howey it may still be a security, justified thru some other definitional matter;
a. Marine Bank v. Weaver pg 24 - US 1982: - Warren court – Sale of CDs insured by FDIC;; It
was a business arrangement btwn parties involving lease of a barn;
b. Held – CD not security even though met definition of security; b/c FDIC insured & banking laws
c. CASE FUMBLES –not matter if it is not something that comes to mind for it to be security –
since creative instruments are fine; private vs. public not matter b/c private can be security; not need
publically traded – b/c many securities are not; and no prospectus delivered not matter b/c can have
security w/o prospectus;; ALSO risk has nothing to do w/ deciding if it is a security or not;

d. MARINE BANK: - not a security even if pass Howey or 33 definition if

i. Better Regulatory Scheme Exception aka Alternative regulatory protection Test– if there
is another regulatory body/law better suited to deal with a given transaction (banking laws) –
then trump securities laws [but not fool proof]
1. So can pass howey and still not security- b/c better reg scheme makes registration
an onerous and unnecessary burden; and
2. Marine bank–CD issued by MB not security b/c FDIC & banking laws adequate
protct
3. Teamsters v. Daniel & Matassarin v. Lynch - pensions not securities (law)have
ERISA
ii. Uniqueness Exception – if offerings has uniqueness such that no other investor could take
part in it; then probably not a security; that would be overreach by 33 act and inefficient
“dissemination of information requirements of the acts are justified by economies of scale”
that do not exist in unique transaction;
1. Marine bank barn investment very unique to parties – no other investor could
share in;
2. Consistent with capitalism – need many investors
3. Also Unique not mean NOVEL – ie no one thought of it before; -- NOT matter if
not come to mind when think of security – creative instrument can be security;

e. Reves – even though note in security def – not all notes securities look at purpose of act
f. HOWEY test – has nothing about risk – as risk is irrelevant and has nothing about the
sophistication of the investor

d. ASSOCIATIONAL FORMALITIES: Interests in Corporations, Partnerships & LLCs as Securities:

i. Stock as Securities - maybe presumption for it to be security but still Howey and Forman
1. Economic reality (common sense test) – FORMAN – just b/c something is called stock does
not necessarily mean that it is a security/stock – notwithstanding the lanaguage of §2(a)(1) that specifically
includes stock b/c look at Substance over Form;
2. Sale of Business doctrine–if there was a sale of 100% of stock of the business then not selling a
security, b/c selling control, can’t be selling efforts of others [howey] so not investment BUT overruled by
Landreth
a. Landreth Timber Co v. Landreth–pg 46 US 1985–overrule SOBD said selling stock was stock
so §2a1 security–but do not read this as overruling economic reality test of Forman & Howey which
says look at substance over form – real intent is purchaser of 100% security is still protected by
Securities laws and Landreth was really stock.
i. WORK around – if sell 100% securities to buyer then securities transaction if sell all assets
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 and liabilities of Co. to buyer than not a security transaction;
ii. Partnership as Securities -§2(a)(1) – not mention partnership as list of securities definition but structure of
partnership does have implication of whether or not it is a security-
1. General Partnership – are generally not securities b/c fail efforts of others prong. Each GP
manages the business & bind the partnership (or has right to) so GP interests are not considered securities
a. BUT if called a GP but not really true general partnership since few attributes of GP only few do
all managing–a security can be found (KOCH v. Hankins); Forman Economic reality works both ways
b. Chinchila – farm got investors from all over country – called GPs but still was security b/c pass
Howey – there is efforts of others b/c investors did nothing – not know about farm [sub over form]
c. Pg 56 – Law firm hires associate from other firm to join as GP – but finds out after joins firm is
going down and now can sue in torts or K but wants to sue in securities fraud – if truly GP not satisfy
Howey – efforts of others so can’t sue in federal; but if GP not do mngmtn and senior partners do it –
then maybe can; BUT also investment of $ if 35K buy in is it investment to grow or is it just entry fee –
more like forman – not investment of money;
2. Limited Partnership – generally considered securities b/c passivity requirement – have efforts of
others b/c limited partners have no management control GP does that; so LP interest is security – passes
Howey:
a. Steinhardt v. Citicorp – pg 50, 1997 3rd cir – D wanted securitze non-performing loans to get
off their balance sheet so dumped them in LP and sold LP interest to P; LP agreement gave P veto
power (control etc while still preserving DE Limited liability); P sued D but wanted federal so under
securities fraud; CT said efforts of others test was not met- so this is not security – b/c P had veto power
so not a passive investor – SO FORM – calling it LP not automatically mean securities; (no black letter)
i. Again substance over form – like Howey and Forman economic realities – name not matter
iii. Limited liability interests (LLCs) as securities–Howey test– if members have significant input then not
security–fails efforts of others (ie member managed); if members are passive – then it is security
iv. Real Estate as Securities – normally real estate transactions are not securities – but if more than simple txn
and pass Howey test than can have security – LOOK at expectation of parties – intent to invest in business for
profit, is there commonality, and is investor relying on efforts of others?
1. SEC Release 5347: ANY the following will aid in a condo (purchased directly from a developer) being
an investment contract: emphasis on economic benefits derived from managerial efforts; offering of
participation in a rental pool arrangement; unit must be offered for rental at any time in the year, use an
exclusive rental agent, or otherwise restricted in occupancy or rental of the unit.
2. Hocking v. Dubois – pg 60 1989 – 9th cir – P buys condo in HI form owner in the secondary
market – NOT from the developer. Broker told P that the condo could be put in pool and rented out. CT
applied Howey – said it was security – created by broker in the aftermarket, investment of $, and
purchased w/ expectation of profit, had rental pool agreement so passes Horizontal comm.(and vertical
Comm); issue was efforts of others;
a. KEY – all things have to be offered in one package – the mgntmt agreement (to maintain thru
maintenance fees), rental pool agreement – cannot get it separately
b. HERE broker created the security even though developer had nothing to do with broker/agent; &
if owner used it once a year – still can be security – Forman – consumption/use and economic reality
c. Case remanded b/c denied SJ – not say sec for sure need more info on level of control by investor
v. Notes (IOUs) as Securities -2(a)(1) defines securities to include notes (debntres/bonds) but not mean all notes
1. Notes like stocks – very name in statutory definition may mean presumption it is a security but: do not
abandon both the HOWEY test and economic reality test (forman).
2. TWO fundamental types of notes: SO Notes – look at intent of parties:
a. Investment Notes – these are securities (bonds/debentures) if business borrows money then –
they are securities – ie notes for capital improvements, or expansion, general business interest;
b. Commercial Notes – NOT securities – used for commercial purpose – used to finance short term
assets, bank financing, commercial asset financing, inventory financing – these notes are not securities

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 i. accounts receivable -people buy on credit– Business sell A/R at discount to bank to finance
business (pay EEs bills etc) can’t do it w/ A/R so borrow against it – this is commercial loan
ii. Inventory – short term borrowing- dealer not own every car on lot – borrow against inventory
1. If only equity capital used to buy inventory – then limited but if more inventory
can sell more so borrow against inventory and when sell inventory pay loan and buy
more
iii. Can’t require registration of all these notes – it would restrict business too much
iv. SHORT term – usually 1 year max but expectation is pay back in 30 to 60 days

c. REEVES v. Ernest & Young- pg 67 US 1990 (differentiate investment vs commercial notes)–

Family Resemblance Test: There is a presumption with respect to notes that they are a security but if
the following four part test is met [all 4 parts] a note will not be deemed a security
i. Motivation of the parties –
1. Buyer – is motivation of buyer an investment (earn profit) then security – or is it
commercial purpose – short term financing (not security)
2. Seller – is it for commercial or consumer purpose (not security) or for general
business purpose (security)
ii. Plan of Distribution – to whom selling the notes/is instrument meant to be traded
1. To the general public – investment note (a security);
2. If to people in business of financing short term assets – commercial note – not
security
3. Is note designed to be traded – investment often have ability – so security – and
commercial notes almost never ability to trade – not security
iii. What are the Reasonable Expectation of investing public (would finance world consider it
investment note or commercial note)
iv. Is there Another regulator scheme better suited to deal with the instrument (Teamster)
[risk is relevant in Reeves – debt but not capital - Howey]

vi. Separate Security Issues (pass through security/trust) –make security out of basket of non security stuff –
creating security separate from mere ownership of something (ie the scotch) that is not security
1. Examples of Securitization – (making security out of something that doesn’t exist as security by
selling interest in it) – Scotch, orange groves, credit cards, debt/home mortgage;
a. Pass through – simple residential mortgage is not security – but pooling mortgages and selling
undivided interests is a security, where value is derived from mngmtn of others
2. Scotch Example – 12 year tie up – can make a security out of common basket of non-security
stuff (buying stuff that’s not a security but set up a trust using others money to buy those things and hold it
-then interests in the trust are a security) – created a separate security then if meet Howey have a security –
SO put scotch in trust and sell interest in the trust – created and sold securities
a. Scotch needs to age in oak barrel distillery can’t age it in the bottle like wine – so Distiller has to
keep scotch for 12 years and can’t sell it so can make security out of it
b. Buying 50 barrels of scotch is not security but: if Setup a trust and sell interest in the trust – say
10 investors each 1000; The trust then buys the 50 barrels of scotch from the distiller and then distiller
takes money and use it to make more scotch etc
c. Once barrels ready and sold the trust pays off all expenses and returns money to investor at say
double the money invested – This is securitization; and if pass Howy is security
3. Accounts Receivable Example – common security – MC/Visa – go to restaurant pay w/ card- the
restaurant has no money but has to go buy new food etc and pay expenses, so they sell their A/R – to MC
or AMEX etc – who buy their credit card receipts owed at a discount say 92cents/dollar and rip a check to
the restaurant the next day so they can run their business and then AMEX/MC holds the receivables; BUT
AMEX/MC need lots of money to do this – buy of credit receipts etc – so they put all the recievables and
package them and securitize them and sell them to investors who buy into the trusts and if want out can
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 sell your interests; SO for MC/AMEX –need not wait for us to pay off our bills – securitize them to get the
money; MC is selling interest – securitizing them but they are not securities for MC (the receipts)
4. Mortgage Example: - have 30 year mortgages can’t wait that long for payment – want to do more
mortgages - so securitize them and setup trusts w/ all these mortgages and then sell interest in trusts to
investors; The trust is divided into tranches, where the mortgages always to be paid on time are section A
and their investors get lower interest rate then say the riskier mortgages of the pool say the bottom have –
so their investors get higher interest rate;
a. But 100% of the bottom defaults and investors got nothing and then no one started buying into
the trust so couldn’t really trade it and sell out and so can’t value the trust either since not sellable – so
banks now can’t get money to pay for other business b/c tied up in these assets that can’t be sold or
valued; so illiquidity and gridlock; SO govt TARP – buying some of these assets to banks lend more
b. Past Savings and Loans bank – kept the mortgages so slow growth b/c can’t lend more unless get
more depositors – this would be equity loans only but leverage and securitization allows faster growth
and more loans
vii. REMEMBER:
1. Once a security always a security; and if investment says stock presumption it is security

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III. THE Public Offering
a. Overview – Offering securities – Issuer can 1. Sell it to the public (Ma and Pa America) or 2. Sell it privately. A
company that wants to sell stock (a security) to the public goes to an underwriter (Ibank) to buy the stock. The
underwriters are retail distributors of securities and distribute the stock to the public.
b. Terminology:
i. Issuer – any person (ie company, enterprise, entity) that issues securities
1. Like Co issue common stock, or partnership issue membership, or trust take on investors
ii. Underwriter–more later–any entity that buys the securities from the issuer & then sells them to a distribution
network (brokers). Underwriters are essentially the wholesalers of the securities industry (middleman)
1. Ie when MS wants sell securities to the public, not know who is interested so use underwriters who
contact brokers who know who want to buy stock.
iii. Primary Offering - any offering by issuer itself; when the issuer itself sells securities
1. IPO – initial public offering – first time issuer offers securities to the public – the first primary
offering
2. Public offering – any time issuer offers securities after the IPO to the public
3. Private offering – a non-public offering
4. (IE Each time MS sells its securities it is a 1˚ offering, can only have one IPO, any other offer by issuer
are just primary offerings)
5. Secondary offering – offering of securities by someone other than the issuer,(which requires
registration)
a. ie Insiders, control persons, affiliates (CEO, BOD, Majority SH) sell stock may need register
b. If Gates wants to sell MS its secondary offering & may need registration.
c. Generally these are statutory underwriters and affiliates under §2a11 but still must be concerned
with §5 registration or seek exemption under 144, 4 (1/2) or Reg A.
6. Secondary Trading – after market trading- trading of securities in the open market by the
average person. It has nothing to do w/ secondary offerings and the securities have already come to rest in
the public. It is exempted from registration –
a. ie buy/sell securities by persons other than issuer or person who must concern himslf w/ registrant
7. THE 33 act only concerns itself with primary and secondary offerings and Nothing to do with secondary
trading/transactions. The 34 act is primarily concerned w/ secondary (after market) trading.

c. SECTION 5 of the ’33 Act - this is what the ‘33 act is all about. Everything else is commentary
i. Intro: Absent some exception/exemption, it is unlawful to offer a security unless registration is filed w/ the
SEC & unlawful to sell/buy security unless registration statement is in effect. Registration is of the offering.
1. Theory – behind ’33 act is consumer protection and disclosure by the issuer every time sells
securities so the investor can make an informed decision; Risk is irrelevant can sell risky securities just
need to disclose
2. Registration statement: 2 parts: 1. Prospectus – is a disclosure document/sales brochure and 2.
SEC forms (housekeeping); This registration statement is what every issuer must draft up and file with
SEC.
3. ’33 and ’34 act are criminal statutes – says it is unlawful.
4. Section 4(1) - Section 5 not apply to any person other than ISSUER, UNDERWRITER and
DEALER
a. 4(1) exempts secondary trading (we buy/sell stock) from ’33 act–only concern is 1˚/2˚ offerings

ii. § 5(a): Unless a registration statement is in effect as to a security, it shall be unlawful for any person, directly
or indirectly-- 1. 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; or 2.
to carry or cause to be carried through the mails or in interstate commerce, by any means or instruments of
transportation, any such security for the purpose of sale or for delivery after sale
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 1. unless registration stmt is declared effective by SEC its unlawful (criminal ramifications) for any person
(not mean human being) to sell a security; Reg stmt expires after 9mos so need new reg to reissue after 9m
iii. § 5(c): It shall be unlawful for any person, directly or indirectly, 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, unless a registration statement has been filed
as to such security, 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
1. Once registration stmt is filed but even before it is effective can make offers to buy or sell. BUT Before
registration is filed can’t offer to buy or offer to sell any security,
iv. §5a/5c – interpretations:
1. Unlawful – so criminal statutory ramifications – jail, fine etc
2. Any person - §2(a)(2) – “person means an individual, a corporation, a partnership, an association..trust…”
3. Commerce clause language –if Constitutional challenge as to whether Congress has power to pass sec reg
4. 4(1)–sec 5 only applies to issuer, underwriter, and dealers; so any offering by them (ie sell stock) must be
registered (have effective registration stmnt) and so secondary trading is exempt (not issuer/under/deal);

v. Registration Statement: bulk is prospectus other part is housekeeping stuff;

1. SEC thru regs tells what to include in registration stmnt; once effective can sell securities;
a. Sue if registration statement is misleading/material omission; can’t sue on preliminary prospectus
2. Prospectus –
a. a disclosure document/ sales brochure, whenever issuer/underwriter sells a security it must send
prospectus to the potential buyer to inform them about the security; Finances etc;
b. Prospectus must comply with §10.
3. Purpose is disclosure –
a. good,bad,ugly to investor to make informed investment decision; risk irrelevant
b. Buried disclosure is no disclosure at all
4. Reading Level: -
a. written in plain English at a NY Times reading Level (no legalizes/jargon)
5. Standard for Drafting: [TRUTH is not the standard] ----see Materiality SECTION pg 15
a. Statements can’t be materially misleading
i. So if truth Chinese market for telephones is 1BN, can’t put that in prospectus for small
company seeking to raise capital to make phones b/c misleading gives the impression he can
play in that market but really can’t [can say idiot if buy stock no one sues but it is sales doc]
b. Anything material must be included
c. [tension – if disclose everything and too much bad stuff no one buys stock, if but if not disclose
then sue later on if material] also drafter of reg statement needs to know all can’t rely on managers.
6. ’33 act sec 5 - Registration statement is registration of the offering not the stock/security –
a. No such thing as registered security. Securities sold correspond to registration stmnt; SO if MS
issues stock to public (stock cert 123) under a registration stmnt & MS wants to buy it back (treasury
stock) & then resell to public some time later –MS can’t unless a registration stmnt is in effect to sell the
security since old one is outdated, stock is not registered
7. Shelf Life is 9mos from date of latest financial information in the registration statement
-info get old
a. SO use latest financials in reg statement b/c if 6mos old only have 3 mos left on it
b. Not mean it is better to buy stk from issuer not 2˚ trading b/c want all info &prospectus only from
issuer offerings b/c 34 act requires prospectus type info be available to the public; so 2˚ trading is ok.
8. Fraud for prospectus is longer SOL than the 9mos– (3-5Years?)
9. FORMS for Registration Statement:
a. Make disclosure easier–integrated disclosure forms–REG S-K (Co. info) & Reg S-X (accting inf
b. S-1 = list of questions to be answered in prose, used by anyone who not qualify for short form,

11
 which established Companies use. Every IPO uses S-1, this is default form;
c. S-2 = shorter form for more seasons companies
d. S-3 = even shorter form for even more seasons companies – lots of info out there
e. S-4 = for mergers
f. S-K =complete package of questions -forms above reference S-K by stating which Qs to answer
10. Disclosure required by Forms/registration statement:
a. Info wrt to the registrant
i. S-K - Descrip of business, director security ownership, comp, hi/low prices, legal
proceedings; S-X need financial stmts and income stmts, audited
b. Distribution of proceeds: underwriter describe agreement w/ issuer and use of proceeds
c. Securities of registrant–rights/privileges/ preference of securities offered; price disparity to dirctrs
d. Exhibits: not part of prospectus, ie lawyers opinions, articles of incorp
e. Everything else material to an investor and anything issuer believes investor should know

vi. REGISTRATION PROCESS:

1. Once Registration stmt drafted (by Sec Lawyers) submit it electronically via EDGAR (electronic data
gathering and retrieval system), SEC then reviews and comments on it (but not verification of mertis) –
thru a comment letter. Issuer responds by filing amendments – go back and forth for a while;
2. After all comments are incorporated and amendments filed – registration statement is declared effective
3. Once registration statement is effective securities subject to that registration can be lawfully sold to the
public under §5(a); (before could just offer 5(c));
4. SEC – can’t refuse to declare registration effective under statute and prevent sale- if make all proper
disclosure/amendments but can keep commenting;
5. NO Merit Review: - SEC doesn’t verify if all correct, just b/c declare registration effective not
mean SEC signed off and verified all statements are true; So disclaimer says on prospectus SEC review
not means sign off on everthing;
6. Timing §8(a) – SEC has 20 days to declare registration statement effective
a. But every issuer that files registration statement makes a voluntary amendment waiving the 20
days for SEC benefit. Quid pro quo – in Return -SEC will allow the issuer to go effective on the
date/time of his choosing, once everything is ready to go effective near completion of review. (also get
good faith working relationship w/ SEC); [timing offer is critical]
7. Can take weeks to months to prepare registration statement & is very expensive (ie 90K for
10MN offer)

vii. GUN JUMPING

1. Overview: gun jumping is any efforts/touting made to promote the sale of stock, even indirect
efforts to pre-condition the market, prior to registration – these are deemed to be tantamount to making
offers in violation of §5(c) [illegal offers]. Guidelines change w/ each phase of the registration process.
2. Conditioning the market - when issuer, underwriter or dealer attempt to condition the public
and arouse public interest in the issuer as a prelude to undertaking a public offering.
a. Prefiling Hype = disguised offer of security; - SEC not like
3. Statutory and theoretical basis for prohibiting pre-conditioning of the market is found in the
broad definition of “offer” of a security set out in §2(a)(3) of ‘33act.
a. SEC position: Pre-Conditioning of the market is in reality a disguised offer to sell securities,
which are subject to the upcoming offer. And under §5(c) an offer to sell securities absent some
exemption may be made only thru a prospectus (part of the filed registration statement).
b. SEC v. Loeb, Rhoades Co. 1959- LR was going to underwrite an IPO and started advertising
how great the security was BEFORE a registration statement was filed so getting the market excited
about the offering. SEC took position that pre-conditioning the market prior to the offering was a
disguised offer b/c LR was garnering interest in the Co., even though the security was never mentioned

12
 by LR’s press releases etc – SO this was a violation of 5(c) and gave rise to concept of gun jumping.
i. Though can do normal self promotion but not was LR was doing as underwriter

4. “IN REGISTRATION”: TIME FRAME:

a. One has to worry about gun jumping when one is “IN REGISTRATION”
i. Prior to “in registration” can do whatever you want; (subject to fraud limitations)
ii. Once “in registration” rules as to what can be said and done; like no offer until filing
b. Conservative analysis -issuer is in registration once senior management has made a good faith
firm decision to proceed with a registration (Jalil like this)
c. Liberal analysis – an issuer is not “in registration” until a letter of intent has been signed w/ an
underwriter. So in registration at a later point.
d. “In Registration” begins in either case before registration statement has even been drafted or filed
i. Issuer is also called registrant;

5. REGISTRATION PROCESS – 3 PERIODS:

a. Pre-Filing Period aka Quiet / consistent period – the period between when the issuer is “in
registration” & the filing of the registration statement
i. Can’t make direct or indirect offers; no conditioning market, no appearance of offers
ii. ONLY allowed consistent remarks (oral/written), underwriter negotiations(2a3) or rule 135.
1. Not really quiet period b/c law only requires be consistent;
iii. Consistency allowed: During Pre-filing pd an issuer should carry on as normal but should
clear all public communications through securities counsel and refrain from giving forward
looking stments or going just beyond the facts & normal advertising & running of the Co.
1. General remarks should be consistent w/ the past.
a. if not ordinary can be seen as disguised offer
2. Example – issuer cannot launch a new marketing campaign;
3. SEC 5180- “there is no basis in secrities acts or in any policy of the SEC which
would justify the practice of non-disclosure of FACTUAL information by a publicy
held company on the grounds that it is ‘in registration’.”
a. public companies have a legitimate reason to disseminate info and make
announcements; as they always disseminate information,
b. privately held (non-public) Co. “in registration” have far less justification
to make announcements/facts unless in news for some other reason.
iv. RULE 135 –Safe Harbor – describes when a notice is not a disguised offer. An issuer “in
registration” may make a rule 135 Com/PR about upcoming offer which contains following
1. Mandatory: legend -Communications must state that an offer may be made only
by a prospectus and that this information given is not an offer. [if no offer no 5c]
2. Permissible items: can include no more than name of issuer, title, amount and
basic terms of securities to be offered, anticipated timing of offer, amount of offering,
whether offer is directed to a particular class of purchases (public/private) brief
purpose of offering;
3. Prohibited items: name of underwriters, offering price; (generally no obligation
until day b/f offer)
v. THUS once “in Registration” can do 135 PR, conduct business and communicate in normal
manner and behind scenes negotiate w/ underwriter; and once find UW start Reg stmnt work.
b. Waiting Period (waiting for effectiveness From SEC) – the period after first draft of registration
is filed and until Registration statement is effective; [have SEC review & back/forth w/ SEC]
i. Gun jumping analysis changes-Generally NO written material allowed except PP; Oral is Ok.
1. b/c all now know who underwriter is and that there is offering to be made
ii. Still can’t sell security - §5(a) until registration statement is effective
iii. Oral offers / Oral statements allowed – [no radio/tv – they are seen as prospectus?]
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 1. BUT: Offers subject to qualification – are to solicit “indication of interest” on
part of the buyer and No binding offer or acceptance may be made (and no sales
consummated, $$ accepted) until registration statement is declared effective.
2. No limitations on what can be said can make offers just can’t be accepted
3. Underwriter doing lot of oral sales efforts during waiting period and using
PrePros
4. (once effective either at or prior to confirmation of the sale customer must
receive final prospectus)
iv. Writing–3 things allowed Preliminary Prospectus, Underwriter negotiations, rule 134
1. Preliminary Prospectus aka Red Herring: Written offers maybe only made
thru preliminary prospectus – no statutory requirement that preliminary prospectus be
distributed, SEC position - it will not grant effectiveness to registration statement until
it gets assurance from underwriters that PrePros in form closest to final prospectus was
circulated to all investors who demonstrated indication of interests. [reduce surprise
when final prospectus comes with or prior to confirmation of order]
a. RED Herring – red legend – says Preliminary prospectus / incomplete
prospectus and gives indications of possible changes
b. Amendments – need to keep sending prospectuses out – SEC not grant
effectivenes unless most recently circulated PrePros is substantially same as final
c. Final preliminary need circulate at least 48 hours b/f effectiveness
and if final prospectus will materially differ from final PrePros – then have to
Re-Circulate FINAL PROSPECTUS since not substantially same as PrePros
and should wait 48 hours. Usually if material diff. just Re-circulate PrePros and
then wait another 48 hours before effective. [only pricing information should
differ]
d. Underwriter circulates this broadly to get interest
Rule 134 2. RULE 134 – tombstone ad – safe harbor of what can be included in an
Communications not announcement regarding the offering to be made – once a registration statement has
deemed prospectus been filed:
a. The term prospectus shall not include a notice, circular, ad, letter or other
communication published or transmitted to any person after a registration
statement has been filed if it contains only the statements required or permitted:
i. Communication May include: name of issuer of security, full title of
security and amount being offered
ii. Communication Must include: following (if reg stmnt not effective): “A
registration statement relating to these securities has been filed with the SEC
but has not yet become effective. These securities may not be sold nor may
offers to buy be accepted prior to the time the registration statement becomes
effective. This communication shall not constitute an offer to sell or the
solicitation of an offer to buy nor shall there be any sale of these securities in
any state in which such offer, solicitation or sale would be unlawful prior to
registration or qualification under the securities laws of such state.”
c. Post Effective Period – after registration statement becomes effective –
i. Formal offers can be made and accepted and sales may be consummated
1. Any sale consummated it must be accompanied or preceded by a final prospectus
– unless shown that investor already has a copy of final prspct–like multiple sales to
him
ii. Issuer/underwriter can choose effective date
iii. Investment decisions usually based on preliminary prospectus b/c trades get done instantly
once registration is effective
iv. §5(b)(1) – requires that after registration statement is filed and effective, all written offers to
14
 sell must be in connection with a prospectus that complies with §10 of ’33 act
v. §5(b)(2) - requires final prospectus is required to be delivered w/ security when delivered
1. Rule 434 – do not need to send complete prospectus can send multiple docs
which collectively contain all the necessary information.
vi. DOCTRINE of FREE WRITING – once registration statement is declared effective can
write/say whatever you feel so long as communications is accompanied by final prospectus
1. Waitng period no written comm. Except PP or rule 134 –but once effective -all
free writings are no longer prospectuses (as were in past) so not need safe harbor
2. Need good faith that mailed prospectus
vii. PROSPECTUS DELIVERY
1. ISSUER must continue to deliver prospectus under §5(b) so long as they are
offering security to the public
2. Underwriters and dealers – need to distribute prospectus so long as there are
shares remaining in their allotment
3. Nonparticipating dealers – must deliver prospectus for 40 days after effectiveness

6. NEGOTIATIONS with Underwriters:

a. §2(a)(3) – excludes any preliminary negotiations between the underwriters and the issuer or
among underwriters who are or are to be in privity of K w/ issuer from the broad definition of “offer”;
i. w/o this issuer would not be able to discuss offering w/ prospective underwriter b/c it would
be considered an offer, and then could not do any offerings; [so even pre-filing can do this]

7. SHELF REGISTRATION: - SEC will not accept registration statements and review them
unless the issuer has good faith intent to make the offerings and go effective ASAP.
a. Exception – Rule 415 – Shelf Registration Act – certain large issuers that meet certain tests can
file shelf registration statements in advance and keep their information current with the SEC and go
effective whenever they want to issue the securities;

8. BLANK Check Companies - RULE 419 – some companies raise money w/ no particular
purpose for that money in mind. RULE 419 – must keep that money in escrow until the purpose is
disclosed to the investors and they approve of it:

9. GUN JUMPING EXAMPLES: pg 172/179/186

a. Pre-filing period –
i. Co. puts add in business week touting company but previous ads were in BYTE –not allowed
1. Need to remain consistent once in registration (good faith to do offering)
ii. Co. VP starts talking to Ibank about an offering or solicits more Ibanks– Fine - §2a3;
iii. Co. tells Ibank – will get commission if move their stock – illegal offer?
iv. Co. VP sends written agreement w/ underwriters to Co’s other office – fine w/in Co
communications – not commerce clause power – even if interstate.
v. Jane hears of offer and writes in offering to purchase – illegal offer and can’t be accepted
vi. Ibank issue statement disclosing Co will do offer and what its for and how big – OK rule 135
but can’t identify underwriter in pre-filing period
vii. Co sends out annual reports – fine if consistent but now say its glossier – problematic
viii. Co. VP to give speech arranged prior to being in-registration – fine as long as consistent
b. Waiting Period:
i. Co issues PR announcing filing of reg stmnt and offering – no good b/c offers must be thru
preliminary prospectus or orally – but rule 134 safe harbor can name underwriter
ii. Broker at underwriter calls jane and tells her to buy some stk and sends preliminary pros –
OK as long as solicitation for indication of interest
1. orally can say anything – no matter how strong armed but only written is PrePros
15
 iii. Broker sends note to Jane says this is a good buy – NO good only writing is PrePros or 134
iv. Check sent to broker for shares – NO good – can only solicit offers – not sell
v. Third party not involved in offering places info on website about offering – OK – can say
whatever want if not involved
vi. Co puts hyperlink on website linking to third party report – NO good
vii. Underwriter sends letter to Jane describing other stock in Co and how good it is – should be
fine unless seen as rousing interest.
viii. Broker send PrePros to all known – and follow up phone call – both fine
c. Effective period og195
i. Sally mailed a prospectus – she never sees it and puts in for 100 shares – THIS is ok just need
good faith that mailed prospectus
ii. Can send anything post effective as long as accompanied by prospectus

16
viii. MATERIALITY OF INFORMATION – standard prospectus are held to
1. A prospectus will be actionable if a statement or omission is Materially Misleading.
a. So if say 10K sq ft warehouse and actually 9998sqft – can’t sue – not material
2. Truth is not the standard – a true statement can be misleading
a. And if lie still cant sue unless material – so say director is 58 but he is actually 60
3. Even if the registration form not specifically ask for it – if it is material it must be included;
4. There is no liability if the misstatement/omission is immaterial.
5. IF something happens after the prospectus-need to amend prospectus–Post Effective Amendments

6. What Rises to the Level of Materiality – (ie must be in prospectus)

a. Reasonable Investor Standard – “a fact is material if there is a substantial likelihood that a
reasonable investor would consider it important in deciding whether to invest” (TSC v. Northway)
i. This is an objective standard – reasonable investor – not based on individual preference
b. 5% Rule of Thumb - something is generally material if it reflects 5% of earnings or income or
net assets; [not bright line test – should not survive SJ]
c. Market Test – effect on price should be measure of damages not measure of materiality – If we
assume market is efficient and all reasonable investors then maybe if info comes out and stock goes
down then info is material but Market is not reasonable investor?
d. Buried Disclosure doctrine – even if disclosed all material information, that information must
be CLEAR, READABLE, and must be SUFFICIENTLY PROMINENT for its relative importance.
i. Buried disclosure is no disclosure at all, can’t hide
e. IRRELEVANT to materiality if issuer to be harmed by disclosure – and thus must include if
it is material information – see below
f. EXEMPTION of material disclosure – can go to SEC to exempt disclosing material info
i. Ie if legitimate competitive reason not to disclose and if not affect totality of info;
g. Examples:
i. Pg 583 – disease resistant rose in prospectus – small part of business but C bought stock b/c
very impt to him, it was terminated and not told to C; C sues – not win – b/c must be material
to a reasonable investor- can’t be catering to each wacko
ii. OR above lie about age – not material if 59 instead of 57

7. FUTURE EVENTS and Materiality - if future event is uncertain or speculative what to include
in Pro?
a. Basic v. Levinson-pg 584 US 1988 – Co was in merger discussions and did not mention it and
argued that uncertain if it will occur so not discuss it. CT–paternalistic approach to materiality is no
defense. It is material if substantial likelihood reasonable invesor would consider it important and
significantly alters total mix of info available – adopts TSC position;
b. Probability magnitude test –to determine wrt contingent or speculative information or events,
whether it is material and should be included depends at any given moment upon 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
i. PJ – assign number to both probability and magnitude if sum exceeds X then disclose it;
ii. Issue is if include something that not pass the test it can be misleading – like say we are
thinking about merging -there is high magnitude but very low probability it will occur;
iii. SO Gates says in golfing takeover Co, or acquisition dept calls – farily low probabitly but if
MS’s inv bank calls – now have high probability
iv. FLIP–high probability buy truck next yr-already have 200 trucks low magnitude no disclosre

c. ON GOING DUTY TO DISCLOSE – once issuer has disclosed something must continue to
disclose and reveal it;
17
 i. past could remain silent on material info btwn filings 10Ks ’34 act and disclose when file but
SOX duty to keep disclosing material info in real time
ii. SOX §409 – each issuer under 13a and 15d (every public co) shall disclose to public on a
rapid and current basis such additional info concerning material changes since the financial
condition or operation of the issuer in plain English, which may include trend, qualitative
determinative which would be necessary or useful to investors.

d. OBVIOUS FACTS: - some facts are so obvious that even if they are material, the issuer doesn’t
have to disclose them (if obvious or common knowledge) –
i. stock bought at 10 now 8–material & prospectus not say stk can go down – not need disclose
ii. Wieglos v. Commonwealth Edison Co – constructing powerplant – obvious it could have
cost overruns; it happened so many times – so not need put in the prospectus
iii. SEC not want huge overloaded prospectus
iv. TRUTH on MARKET – misstatment not material b/c savvy investor knew prospectus wrong
and stock price moved accordingly – efficient market accounted for inaccurate info

e. DISCLOSURE OF SOCIAL CONCERNS/Non quantifiable facts: - to what extent must

issuer disclose social concerns and social action and info not in best interest of company
i. Social issues –gray area –
1. Bribery - SCHLITZ – beer marker needs to pay of distributor or Co loses – so
doing something to help company but still reasonable investor would want to know
2. Also illegal activity, health issues all need be disclosed
3. Deals with integrity of mngmt if material to that want to know it
4. Even if non financials not come to % mark – disclose if material – if reasonable
investor would care;
5. Foreign Corrupt Practices Act – any international payoffs must be disclosed
ii. Need to disclose even if bad for SHs
1. Ex. Pg 592-11-2; A finds out her factory encroaches on neighbor & if find out
will have factory torn down – so if disclose bad for SHs today but not matter b/c
material info so must disclose in prospectus
iii. Don’t have to disclose – trade secrets

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IV. TRANSACTIONS EXEMPT FROM REGISTRATION

Things an issuer can use Things a control person can use Things a reporting Things a private Things investment
company can use company can use companies can use
3(a)(11) [Rule 147] Rule 144 (only if public co.) Rule 505 4(2) [Rule 506] 4(2) [Rule 506]
4(2) [Rule 506] 4 (1 ½) 4(2) [Rule 506] Rule 504
Rule 504 Reg A (only if non-public co.) 3(a)(11) Rule 505
Rule 505 Reg A
Reg A (only if non-public co.) 3(a)(11)
3(a)(9)

a. Overview:
i. Offering/sale exempt from registration process of §5 of ’33 act.
ii. There are Exempt transactions – exempt b/c manner in which security is being offered
iii. There are Exempt securities – exempt b/c type of security being offered; (ie US treasury bond)
iv. TYPES of exemptions: §5 can’t offer security w/o registration
1. §2(a)(3) – underwriter negotiations and agreements permitted b/f registration – not an offer
2. §4(1) – registration requirements of §5 only apply to issuer, underwriter and dealer wrt that
offering – so not apply to secondary trading (but does to secondary offering – ie someone other than issuer
offers)
3. §4(2) – registration reqs of §5 not apply to transactions by issuer not involving public offering
4. (both §4’s are exempted transactions)
5. §3 – exempted securities – but drafting error has both exempt securities and certain exempt
transactions.
a. Ie §3a11 – intrastate exemption is an exempt transaction; §3b – plenary power up to 5MN

b. §3(a)(11) – Intrastate Exemption – “any security which is part of an issue offered and sold only to persons
resident w/in a single state or territory, where the issuer of such security is person resident and doing business w/in
or if a corporation, incorporated by and doing business w/in such state or territory”
i. This is an exempt transaction not exempt security; and therefore not need any disclosure or file registration
stmnt but still cannot make affirmative misrepresentations (also state laws may require some disclosure)
ii. Rationale: political compromise – states rights advocates in congress when ’33 act passed and act passed on
commerce clause power;
iii. SEC HATES §3a11 and will enforce it strictly – SO one offer or sale out of state and blown;
1. Rule 147 is not the only way to satisfy 3a11 but since SEC strict stupid not to follow 147
iv. RULE 147 – safe harbor – for intrastate offering; if follow Rule SEC not come after you – only for issuer.
1. “The rule shall not raise any presumption that the exemption provided by §3(a)(11) of the act is not
available for transactions by the issuer which do not satisfy al of the provisions of the rule”
2. TEST:
a. ISSUER needs to be a resident of and doing business w/in the state or territory in which all offers
and sales are made (at time of offering) and
b. No part of the issue be offered or sold to non-residents w/in period of time specified by rule
3. RESIDENCY REQUIREMENTS:
a. Corporation & Limited partnership are residents in state in which they are incorporated/organized
b. General partnership –is resident of the state where its principal office is located
c. Individuals – is resident of the sate where he has his principal residence is located.
4. DOING BUSINESS – issuer is doing business w/in a state if: (meet all?)
a. 80% of its gross revenue are derived from that state
b. 80% of its assets are in that state
c. 80% of the proceeds of the offerings are to be used in that state

19
 d. principal office or place of business is in that state;
5. OFFEREES and PURCHASERS: - offers to sell and sales may be made only to persons
resident of state or territory which issuer is resident.
a. Same resident rules above for the purchasers but – Corporations organized for specific purpose of
acquiring part of the issue – will not be deemed to be residents of a state unless all the beneficial owners
of the corp are residents of the state.
6. ADVERTISING UNDER 147 – can use TV, Radio, Newspaper – so can advertise to out of state
– but need to use legend that states offer limited to people in certain state.
7. UNDERWRITERS - on a §3(a)(11) – need not be a resident of state of offering (ie same state
as issuer)
8. RESALE LIMITS: [restricted securities]
a. Security must be hold by residents of the state for 9mos (starting date of last sale or last pmt is
received); and even if one person sells out of state exemption is blown (so no straw men)
i. Tacking: 9mos period tacks back to date of issuance so purchaser can sell to other residents
during 9mos period and no new 9mos period
ii. Best way to control – hold all shares in escrow for 9mos then allow investors to get them
iii. Or have K – that says can’t resale for 9mos to nonresidents or consequences?
iv. IF purchaser moves out of state – depends on intentions to see if destroy exemption
9. TIMING / INTEGRATION: - any offering 6 months apart (before or after) will not be
integrated
a. Can’t do intrastate exemption offering in NY as bulk and then same time do registered offering in
other states; (Residency req prevents doing intrastate exemptions in many states but so does integration)

v. IMPLICATIONS OF §3(a)(11)
1. There is no requirement to give any disclosure under 3a11 b/c not w/in §5; [maybe state laws]
2. Advertising must be reasonably calculated to address the state in question and can advertise to antoher
state as long as have legend noting offer is limited to this state residents
a. But can’t say advertise to all NY MDs b/c know not all live in NY
3. Rule 147 is just a safe harbor if follow it – valid 3a11 exemption – but it is not the only way to satisfy
3a11 but sec is strict on 3a11 enforcement;
4. There is no numerical limitation as to how many people can offer to and can do general solicitation;

c. DOCTRINE OF INTEGRATION: - SEC will integrate 2 or more separate offerings and treat them as one
single offering, if certain factors are present.
i. Integration prevents and issuer from improperly avoiding registration by artificially dividing a single offering
so that exemptions appear to apply to the individual parts where none would be available to the whole.
ii. Integration depends on analysis of specific facts and circumstances; but Follow Safe Harbors to avoid integ.
iii. Five Factors of Integration:(none dispositive) (prelim notes Rule147 & Rel 33-4434) – use if no safe harbor-
1. Are the offerings part of a single plan of financing? (what is money raised for)
2. Do they involve the same class of securities? (ie common stock/debentures)
3. Are the offerings made at or about the same time?
a. RULE of thumb – if offerings are a year or more apart – SEC will generally not integrate, if
offerings 6mos or less apart – SEC will probably integrate; 6mos-1yr apart – look at factors
4. IS the same type of consideration received? (ie one for cash other is securities exchanged for merger)
5. Are the offerings made for the same general purpose?
iv. EXAMPLES:
1. Do a 3a11 and w/in 6mos do public registered offering – if SEC integrates them then in trouble b/c 3a11
exemption is blown b/c had interstate offering; and §5 registered offering blown b/c had solicitation thru
3a11 offering prior to registration statement filed
2. Suppose you offer common stock in NY in Sept. under 3(a)(11). Then you also do a registered offering of
20
notes the same day in all 50 states. The common stock is used to purchase equipment, and the note
offering is to hire more salesman. To argue that the two offerings should not be integrated (thus denying
the benefit of 3a11 as to the common stock offering). They don’t involve the same security or class
thereof, but they are offered at the same time. They receive the same type of consideration, but arguably
some are making equity investments while others debt. They are not used for the same purpose

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d. §4 EXEMPTED TRANSACTIONS
i. §4(1) – section 5 does not apply to transactions by any person other than issuer, underwriter, dealer
1. underwriter is defined different see below
2. this exemption allows secondary trading w/o registration

ii. §4(2) – Private placement (non-public offering) – issuer only ---RULE 506 is safe harbor for §4(2)
1. Overview:
a. Opposite of public offering is not private offering (its non-public); lots use this exemption
2. §4(2) Exempted transactions “transactions by an issuer not involving any public offering”
3. Old Test: SEC -4 factor test to see if exemption applies: 1. Number of offerees (35) & their relationship
to each other and the issuer; 2. Number of units offered; 3. Size of the offering; 4. Manner of the offering

4. SEC v. Ralston Purina -pg 276 US 1953–D pet food store -offered securities to its EEs under the belief
that it was not a public offering, nor did D solicit the EEs to purchase shares (253 buy). SEC sued said
offering was made to too many people (>35) to be considered non-public. COURT rejected both
arguments & found that :
a. the public (noun) is anyone who needs protection of the ’33 act
i. public is Financial unsophisticated person
b. A person does not need protection if they have
i. 1. Sophistication (wrt financial matters) 2. Access to information abou the issuer
c. Size of offering and number of people being offered to does not matter. NO QTY limit
i. If sell to one financially unsophisticated person it is public offering and need to register
ii. If sell to 10000 business school professors offering is non-public - §4(2) exemption

5. RALSTON PURINA TEST FOR §4(2) – Non-Public Offering: 3 requirements:

a. Sophistication of investor – stnd – relevant inquiry should be whether the investor can
understand and evaluate the nature of the risk beyond the information supplied to him. The relevant
inquiry should not be whether the investor is knowledgeable on all latest nuances & techniques of
corporate finance. (ABA)
i. It is a question of fact based on business acumen, business experience
ii. Just because wealthy does not mean you’re a sophisticated investor for §4(2)
iii. Issuer can send questionnaire for investor to fill out; (Sec v.Kenton take SSN chk bank no gd)
b. Access to information: (if sophisticated w/o info – no good) can be satisfied in one of 2 ways:
i. Position with Issuer – have disclosure b/c of access to info thru one’s position w/ issuer.
1. Ie – directors or officers – can’t apply to any EE.
ii. Disclosure – investor receives same disclosure had issuer prepared a registration statement –
1. Ie private placement memo
c. No General Solicitation – an issuer can’t generally solicit for non-public offering:
i. This is b/c can’t even make offer to a non-sophisticated person w/o blowing exemption so no
general ads that say this is just for sophisticated persons – (need register to even offer)
ii. SO Issuer can go to Ibank and they can find investors that they know from previous
experience are sophisticated – this way no general solicitation
iii. MUST Reasonbly believe in good faith thru prior info or relation that they are sophisticated –
SEC prefers had relationship w/ them prior so know sophisticated
d. [RISK has nothing to do with it]

e. Courts approach to who is sophisticated (above saw ABA) pg 284

i. 9th cir – sophistication is one of 4 factors – size etc – so not good test can have huge prvte P
ii. 10th cir – persons of exceptional business experience
iii. 5th cir – greater emphasis on disclosures than sophistication
iv. 8th cir – not require sophistication and emphasizes offerees access to information
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v. Others sophistication alone is not dispositive – need access to info

23
e. REGULATION D (Rules 501 – 508)
i. Introduction:
1. Regulation is just a collection of related rules
2. REG D – does double duty exemptions- 1. Two methods to adhere to §3(b) [Rule 504 & 505] which
allows exemption of any kind of offering so long as its under 5MN; 2. Provides a safe harbor for §4(2)
private placement (rule 506 for non-public offering following reasoning of Ralston Purina)
3. REG D – developed by Congress as part of the Small Business Initiative to provide inexpensive efficient
ways to raise capital & still respect the securities laws. Balance protect investors w/ promote Small busin
ii. §3(b) The Commission may from time to time by its rules and regulations, and subject to such terms and
conditions as may be prescribed therein, add any class of securities to the securities exempted as provided in
this section, if it finds that the enforcement of this title with respect to such securities is not necessary in the
public interest and for the protection of investors by reason of the small amount involved or the limited
character of the public offering; but no issue of securities shall be exempted under this subsection where the
aggregate amount at which such issue is offered to the public exceeds $5,000,000.
1. SEC has Plenary (absolute) power to exempt from §5 registration any offering so long as not >5MN
2. SEC can proscribe rules etc regarding this exempt offering of <5MN – RULES 504 and 505;

iii. RULE 501 – Definitions:

1. 501a -Accredited Investor
a. Banks; non-profits: an insurance company: a registered broker/dealer: an investment company
(mutual fund): certain pension funds; a trust or partnership or company having at least $5MN in assets
b. Any director, executive officer, or general partner of the issuer offering securities under REG D
c. Natural person w/ net worth of or in excess of $1MN or having an income of $200K(300K w/sp)
d. And certain other entities
e. [accredited investors are types of persons & entities that do not need protection of Fed Sec Laws]
i. trying to mimic Ralston Purina but Moron Millionaires would not cut it under sophisticated
person stnd of Ralston Purina but still would qualify under REG D
ii. Therefore do not make equal accredited person w/ Sophisticated person stnd of Ralston Pur
2. 501h- Purchaser Representative: A person who is not “connected” with the issuer (unless he or she is a
relative of the issuer) and has such knowledge and experience in financial and business matters to be
capable of evaluating the merits and risk of the investment
a. RULE 506 allows an unsophisticated investor to use a purchase representative to qualify for PPlc
3. 501e- Calculation of the Number of Purchasers: [need in rule 505 and 506]
a. The Following are Excluded:
i. Any relative, spouse or relative of the spouse of the purchase who has the same principal
residence as the purchaser
ii. Any trust or estate in which purchaser and such relative or relatives collectively have more
than 50% beneficial interest
iii. Any Corp or Org where purchaser or persons related are collectively >50% equity interest
iv. Any Accredited Investor
b. A Corporation, partnership, or other entity shall be counted as one purchaser unless:
i. Corporation/partnsp.. was formed for the purposes of purchasing securities in the offering and
is not an accredited investor. [formed for purpose of doctrine] --To determine: Q of fact
1. look@ nature&duration of prior activities, structure of entty, proposed activites
of enty size of capitalizn related to offering (505/506), whether equity owners can opt
out; &
2. 40/60 Test -No more than 40% of the assets of the newly formed corp are
invested in the 505/506Txn and 60% of the assets are invested in real, good faith
investments
3. [so if formed 10 yrs ago no prob, if formed recently then see % assets invested in
offering and % invested elsewhere, but if formed just for offering then no good]
ii. then each beneficial owner of equity securities or equity interests in the entity shall count as a
24
 separate purchaser for all provisions of Regulation D except as to (a) above. [look thru]
c. A non-contributory benefit plan w/in title 1 of ERISA shall count as 1 purchaser where trustee
makes all investment decisions for that plan
4. 501f- Executive Officer: President, VP, senior mngmt who performs similar policy making functions
iv. RULE 502 – General Conditions To Be Met [that are applicable to Reg D each rule picks from this]
1. 502a -Integration – Offerings made more than 6 mos before start of Reg D and more than 6 mos after the
completion of REG D offering will not be integrated (safe harbor)
a. If the issuer does not avail itself to the safe harbor, offerings may or may not be integrated
i. Look at the facts of each case and weigh Five Factors discussed above (pg 18)
b. B/c there are size limits in 504 or 505 offerings if integrate separate offerings can blow exemption
c. If integrate §3(a)(11) w/ REG D corrupt exemption b/c Rul 147 can generally solicit §4(2) cannot
2. 502b - Information Requirements / Disclosure
a. There are no disclosure requirements for certain 504 offerings & offerings to accredited investors
b. Rule 505 and 506 offerings may require disclosure to the investor (if non-accredited)
c. If disclosure is required the following rules must be followed:
i. If the issuer is Not a reporting company (non-public) the issuer must give the investor the
same information it would have given if it had filed a registration statement;
1. Need progressive more detailed financial info as offering size increases: under
2MN; up to 7.5MN and over 7.5MN;
ii. If issuer is a reporting co. it must give the investors copies of reports it has given the SEC
iii. Issuer must also give investors in Rule 505 and Rule 506 offerings the opportunity to ask
Websites are questions and receive answers [not need in rule 504 b/c no disclosure requirement)
tricky – not 3. 502c -Limitations on the Manner of Offerings / No General Solicitation
allowed unless a. There can be NO general solicitation or Ads in certain 504? & ALL rule 505 & 506 offerings
pwd
b. So can’t send out info to anyone you don’t have a preexisting relationship with. [no strangers]
4. 502d -Limitations on Resale / Restricted Securities (502d)
a. REG D offerings are exempt transactions from registration so securities purchased in REG D
offering cannot be resold w/o registration or exemption from registration.
v. RULE 503 – Filing of Notice of Sales – FORM D
1. When REG D offering or sale is made the issuer shall file a notice on FORM D w/ the SEC no later than
15 days after the first sale of securities in the offering [Simple form gives notice to SEC did exempt offrng
vi. RULE 504 – Exemption from Registration for Offerings under $1MN
1. Overview-statutory authority is §3(b) which gives SEC plenary authority to exempt offering up to $5MN;
If requirmnts are met phrase is “Doing a 504”; Rule 504 is to encourage Small business to be created/grow
2. Implications:
a. NO disclosure required
b. Exempt from §5 – registration b/c of §3(b)
c. UP to $1MN in securities offerings ; and no limits on number/character or purchasers
3. Eligible Issuers: (Only a private company)
a. Issuer that are NOT a reporting company, subject to 13&15d of ’34 act (no public co like MS)
b. Issuers that are NOT an investment company (ie mutual funds)
c. No blank check companies – Co w/ no business plan how to use the proceeds of the offering
d. IF NOT above can offer up to $1MN in securities w/o registering
4. Limitations/conditions: [Follow 501 and 502a,c,d—no disclosure(b)]
a. Qualification of Investors Can offer to anyone; and no limit on number of people
i. Investors do not need to be sophisticated, it is irrelevant b/c §3(b) not §4(2)
b. Integration-502a safe harbor can’t integrate offerings made > 6mos b/f or 6mos after this offer
c. Solicitation -502c – no general solicitation (no ads in paper or TV like rule 147 in state offering)
i. Can’t even offer to strangers – just sell to people known or introduced to
d. Restricted Securities – 502d – so cannot be freely resold (follow certain rules ie rule 144)
25
 i. Note: If state law of at least one state where securities sold requires filing w/ state & delivery
of disclosure document to all purchasers even those in states w/o reqmnt or if state law allow
general solicitation so long as sales are made to only accredited investors; then 502c,d not
apply – So there can be general solicitation and securities received will not be restricted
e. Aggregation: aggregate offering price cannot exceed $1MN; [avoid abuses]
i. Count against the $1MN offering limit all §3b offerings (504/505/A) w/in the previous 12 mo
1. ie did 250K 504 offer 1/3/08; now its 7/1/08 – max 504 offering can be done is
750K
vii. RULE 505 – Exemption from Registration Offerings Not Exceeding $5MN
1. Overview–statutory authority is §3(b) which gives SEC plenary authority to exempt offering up to $5MN
2. Implications:
a. Exempt from §5 – registration b/c of §3(b)
b. UP to $5MN in securities offerings
3. Eligible Issuers:
a. Issuers that are NOT an investment company (ie mutual funds)
b. Can offer up to $5MN in securities w/o registering
i. A reporting company (public Co like MS / GE) may use Rule 505.
4. Limitations/conditions: [Follow 501 and 502a,b,c,d]
# of purchasers – a. Number of Purchasers -35- (not offerees); character not matter
Look at 501e i. NO more than 35 Purchasers in Rule 505 Offering [rule 501e–accredited investors not count]
pg 20 1. 505 offering may have unlimited accredited invstrs/relatives & 35 non-accredited
invst
2. Rules pg20–relative spouse trust/estate >50% BO, accred inv all don’t count;
corp is 1
b. Integration-502a safe harbor can’t integrate offerings made > 6mos b/f or 6mos after this offer
c. Disclosure-502b - follow rules laid on in rule 502b
i. if selling to accredited investor no disclosure [so if keep offering all accredited no disclsure]
ii. If selling to non-accredited investor disclose per 502b- like reg stmnt private co; pub SEC rpt
d. Solicitation -502c – no general solicitation or advertisement
e. Restricted Securities – 502d – so cannot be freely resold (follow certain rules ie rule 144)
f. Aggregation: [to avoid abuses]
i. Aggregate offering price in Rule 505 can’t exceed $5MN w/o registration
ii. Count against the $5MN offering limit all §3b offerings (504/505/A) w/in the previous 12 mo
1. Did 504 offer for 1MN 12/1/08; now its 9/1/09 and want to do 505 offer – max is
4MN
iii. NOTE: also for 504 and 505 – previous 3b offering date is the date of completion of the
offering not start of offering; so need count in previous 12 mos any completions
iv. NOTE–only count §3b offerings in 504/505 so §4(2) offerings & §3(a)(11)–R 147 not count

viii. RULE 506 – Exemption from Registered Offerings w/o Regard to the Dollar Amount of the Offering
1. Overview–Rule 506 is the §4(2) safe harbor; statutory authority is §4(2) [non-public offerings] (not §3b)
a. 506 states how to do a valid private placement (non-public offer) under Ralston Purina [sophistic]
b. Can still do 4(2) w/o Rule 506 but take a risk w/ SEC
2. Implications:
a. Exempt from §5 – registration b/c of §4(2) – non-public offering
b. NO limit on the amount of offering–so aggregation is not an issue here &not aggregte w/ 504/505
3. Eligible Issuers:
a. All Issuers may do a Rule 506 offering and utilize this safe harbor;
4. Limitations/conditions: [Follow 501 and 502a,b,c,d]
# of purchasers – a. Number of Purchasers -35- (not offerees)
Look at 501e i. NO more than 35 Purchasers in Rule 506 Offering [rule 501e–accredited investors not count]
pg 20 26
 1. 505 offering may have unlimited accredited invstrs/relatives & 35 non-accredited
invst
2. Rules pg20–relative spouse trust/estate >50% BO, accred inv all don’t count;
corp is 1
b. Nature of Investor: - Need sophistication b/c can’t ignore Ralston Purina
i. Law makes assumption that all accredited investors are sophisticated
ii. 506(b)(2)(ii)- If non accredited investor either alone (or if unsophisticated) through purchase
representative must have such knowledge and experience in financial and business matters to
be capable of evaluating the risks and merits of the investment
1. Thus every non-accredited investor needs sophistication using tests above §4(2)
c. Integration-502a safe harbor can’t integrate offerings made > 6mos b/f or 6mos after this offer
d. Disclosure-502b - follow rules laid on in rule 502b
i. if selling to accredited investor no disclosure [so if keep offering all accredited no disclsure]
ii. If selling to non-accredited investor disclose per 502b- like reg stmnt private co; pub SEC rpt
e. Solicitation -502c – no general solicitation or advertisement
f. Restricted Securities – 502d – so cannot be freely resold (follow certain rules ie rule 144)
5. Examples/ Notes on 506:
a. If had 50 sophisticated investors but not accredited then can’t do 506 offrng b/c 35 purchaser max
i. Can still do §4(2) – non public offering just can’t utilize the safe harbor
b. Can’t Mix and Match Rule 506 w/ §4(2)
i. For Rule 506 – all accredited investors are assumed sophisticated
ii. But if doing a §4(2) offering not rule 506 then every investor needs to prove his or her
sophistication, so if had 1MN net worth – you are an accredited investor but still not
automatically qualify as sophisticated if doing a §4(2) outside of rule 506
c. IF VP of Co wants to participate in the private offering – still needs to prove sophistication or
determine if VP is accredited b/c title alone is not enough – salary or net worth is all that counts
6. RULE 505 and 506 – Key Differences:
a. NO dollar limit in rule 506
b. Need sophisticated investors in Rule 506

ix. RULE 507 – Disqualifications: (bad boy provision) Certain issuers who have gotten in trouble w/ the SEC in
the past for failing to file FORM D may not use RULE 504, 505,506; so can’t do future REG D offerings;

x. RULE 508 – Insignificant Deviations from Term, Condition or Requirements of Reg D

1. Any Insignificant/immaterial deviations from the strict compliance of Reg D does not necessarily mean
that the Reg D exemption is not still available for the given offering (ie not fatal to exemption)
a. Need to show a good faith reasonable attempt to comply and deviation is insignificant
b. Unlike rule 147 for §3a11 exemptions where any deviation is fatal, here SEC is more lenient

27
f. REGULATION A (Mini Registration)
i. Overview: Statutory Authority is §3(b) so REG A is an exemption from §5 registration under §3(b) offering
1. Mini registration is misleading b/c there is no registration just an offering statement.
2. Since under §3b – the maximum offering amount is $5MN
3. Issuer prepares an offering statement FORM I-A and is filed with SEC local office (unlike reg file in DC)
4. Disclosure requirements under REG A are less stringent than those for registration statement
5. REG A Encourages general solicitation unlike REG D
6. Aggregation is odd – REG A only aggregates with other REG A offerings (ignores other §3(b) 504/505)
a. However 504/505 offerings aggregate with all §3b offerings including Reg A w/in previous 12mo

ii. RULE 251: Public offer or sale of securities meeting the following will be exempt under §3(b) from registrn:
1. Issuer requirements (251a): (private co.)
a. Must be a US or Canadian Entity
b. NOT a reporting company (No public company subject to §13&§15d of 34act)
c. No investment companies (no mutual funds)
d. No Blank Check companies (no business plan/purpose or plan is to merge w/ an unidentified Co
2. Amount of Offering (251b): offering price cannot exceed $5MN
a. (insider and anyone else doing secondary offering can do Reg A up to $1.5MN)
3. Aggregation –
a. Reg A offerngs will only be aggregated w/ other Reg A offerngs done w/in the previous 12 mos
b. Reg A offerings will NOT be aggregated w/ the other §3(b) offerings –504 or 505 offerings
i. However 504/505 offerings aggregate w/ all §3b offerings incl. Reg A w/in previous 12mos
c. Example: If do 505 offering Mon. for $5MN can still do $5MN Reg A Tues.– Reg A not aggr
d. Example: If do $4MN Reg A offering on Mon. can only do $1MN 505 offering Tues b/c aggreg
4. Unrestricted Securities –securities issued under Reg A are NOT restricted & may be resold immediately
5. Integration (251c):
a. Reg A offerings will NOT be integrated with:
i. Any prior offerings/sales of securities [that are not Reg A (only have Reg A for aggregation)]
ii. Any later offerings/sales that are:
1. registered under §5
2. made in reliance on Rule 701
3. made pursuant to an employee benefit plan
4. made in reliance upon Reg S
5. made more than 6 months after the Reg A offering
6. Solicitation (251d):
a. NO offers shall be made unless a Form I-A has been filed w/ the SEC [except rule 254 below]
b. After Form I-A (offering statement) has been filed with the Local SEC office, can do oral and
writer offers and advertisements (Print, radio, TV) so allowed general solicitation
7. Doing a REG A:
a. Prepare an offering circular/statement and file w/ the LOCAL SEC office (not DC like norm reg)
b. Once filed but before qualified (effective) can make offers and advertise (radio tv etc)
c. Once form is qualified (effective) can make sales

iii. RULE 254 – Solicitation of Interest – prior to an offering statement;

1. Overview: allows an issuer to test the waters to see if there is any interest in the offering before spending
time and effort to do a REG A offering; or can determine if should do registered offering (waiting period)
a. Thus REG A specifically encourages Gun Jumping b/c gathering interest before filing registration
2. How: An issuer may publish or deliver to prospective purchasers a written document or make scripted
radio or TV broadcasts to determine whether there is any interest in a contemplated securities offering
3. 254d – Bona fide change of intention: (Reg A to registered offering)

28
 a. While testing waters find out there is great demand in security being offered- can abandon Reg A
i. If at least 30 calendar days have passed can then do a §5 registered offering
1. Issuer will not run afoul to gun jumping rules of §5 if wait the 30 days btwn
solicitation of interest from Reg A and filing the registration statement;
ii. Needs to be bona fide change of intention – so good faith like requirement
b. If there is little interest in REG A testing waters and now want to move to Reg D—issues:
i. May have to wait 6mos b/c integration safe harbor from Reg D; since 254 only speaks of safe
harbor to move from REG A to Registered offering;

iv. RULE 260 – insignificant deviations from term, condition or requirements of REG A;
1. These are not fatal just like Reg D
v. Bad-boy – Can’t do a Reg A if disqualified as a bad-boy
vi. No accreditation or sophistication requirement for Reg A investors b/c under §3(b)

29
g. REGULATION S – Offshore Offerings: [handout]
i. Overview: Offerings that occur outside the US are technically not subject to SEC regulations. Reg S 901
delineates when offerings occur in the US and are subject to SEC regulations from those offerings that occur
outside the US and are beyond the scope of the SEC [§5 offer/sale only applies to those occur in US]
1. Issue: is to Define “occurs within the US” [Reg S defines what is not w/in US]
2. Reg S also purpose is to prevent a run around the securities laws by doing an offering abroad that is really
meant to come back to the US. (ie offer securities in Cayman and then next day resold back in the US)
ii. Terminology:
1. Offshore: means non US (even Mexico and Canada are offshore)
iii. R901: §5 registration only applies to offrings that OCCUR w/in the US & Reg S defnes what occurs in the US
1. Exception: US Targeted Offering: any offshore person who directs/targets an offering at identifiable
US citizens as a group anywhere in the world (ie living abroad), then the offering is subject to SEC
requirements and SEC exerts jurisdiction (even if actual offering takes place offshore)

iv. RULE 903 OFFSHORE OFFERING TEST: (if the 2part test is met then Reg S applies not Securities laws)
1. An offer or sale of securities by an issuer/distributor/affiliate is outside the US (and therefore outside of
SEC jurisdiction) if:
a. The offer or sale is made in an offshore transaction AND
b. No directed selling efforts in the US
2. Offshore transaction (902h) – transaction is offshore if:
a. The offer is not made to a person in the United States AND (b or c)
b. At time the buy order is originated, the buyer is outside the United States, [OR]
i. or the seller reasonably believe that the buyer is outside the United States
c. The trade made on/thru a physical trading floor of an est. foreign exchange located outside the US
d. [if the offer is specifically targeted at identifiable group of US citizens abroad (ie military):
i. Then it is not deemed an offshore transaction &SEC has jurisdiction so follow sec laws /reg]
3. No Directed Selling Efforts in the US (902c):
a. Directed selling efforts (of issuer, distributor, affiliate) are activities undertaken for the purpose
of or reasonably expected to have the effect of conditioning the US market for securities offered in
reliance of Reg S
i. Directed selling efforts includes placing an Ad in a publicatn w/ general circulation in the US
ii. General Circulation: any publication that is printed primarily for distribution in the US, or has
had, during the preceding 12 mos, an average circulation in the US of 15,000 or more copies
1. SO if Foreign publ’n sells >= 15K copies w/in US it is directed selling effort in
the US
2. If put add in US edition of foreign publication but <15K circulation still under
SEC jurisdiction b/c it is directed selling efforts if ad in any US edition b/c printed
primarily for distribution in the US.
iii. Example:
iv. if Put Ad in Financial times even if targeted for UK citizen the offering is under SEC
jurisdiction b/c it is directed selling efforts and fails offshore test
b. Not directed selling efforts (902c3 list nots) if the AD placed in foreign Newspaper is required
under US or other law and contains no more information then legally required and has stmnt sec not
offered in US or if US journalist attends foreign press conference

v. Categories of Offshore Offerings (903b): SEC created 3 categories based on likelihood these securities will
flow back to the US. (Check handout; book pg 225 and rule 901/903)
1. Category I (903b1) foreign issuer w/ little or no US connection (foreign issuer and no US Mkt interest)
a. Test for Category I
i. Foreign issuer that has “no substantial US market interest”(in the securities)[902j] OR
ii. Foreign issuer engaged in an “overseas directed offering” [defined 903bii]
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 b. Conditions: Same as offshore test: Offshore Transaction and No directed selling efforts in US
c. Offering Restrictions: None
d. IF comply with conditions and offering restrictions – No SEC Jurisdiction; SEC says not w/in US
2. Category II (903b2) medium US connection – can’t enter US for 40 days after issuance.
a. Test for Category II:
i. Domestic (reporting) or foreign (non-reporting) issuer offering debt
ii. Foreign issuer offering equity who is already subject to ’34 act reporting reqs
b. Conditions: Same as offshore test: Offshore Transaction and No directed selling efforts in US
c. Offering Restrictions: during distribution compliance period (40 days after offering): (902g)
i. Each distributor must agree to conform to Reg S Safe Harbor and
ii. All offering material must bear legend that the securities have not been registered in the US
and may not be sold in US w/o registration or exemption
d. Transaction restriction - during 40 day period
i. Issuer must require purchaser will not sell securities back into the US for 40 days (must
provide reasonable procedures to prevent this)
1. No sales to the account of a US person
ii. Distributions during this period must inform securities Profess. of restrictions on sale to US
e. IF comply with conditions and offering restrictions – No SEC Jurisdiction
3. Category III (903b3) Strong US connection
a. Test for Category III:
i. All other issuers not in categories one and two
b. Conditions: Same as offshore test: Offshore Transaction and No directed selling efforts in US
c. Offering Restrictions: (same as category II) during distribution compliance period (40D/1YR):
i. Each distributor must agree to conform to Reg S Safe Harbor and
ii. All offering material must bear legend that the securities have not been registered in the US
and may not be sold in US w/o registration or exemption
4. Transaction restriction - (40 days debt; 1 year equity)
a. Equity Securities: issuer must ensure equity securities will not be sold into the US for 1 year
b. Debt Securities: Issuer must ensure that debt securities will not be sold into the US for 40days
c. Purchasers must certify not a US person and not purchasing for US person
d. Shares must bear legend barring transfer except in accordance w/ reg S
e. All issuers must have provison in bylaws or elsewhere to empower it to bar transfers not in
accordance to Reg S;
f. IF comply with conditions and offering restrictions – No SEC Jurisdiction
i. BUT if not do reasonable procedures to prevent sell in US for restricted period SEC may
exert jurisdiction
vi. Regulation S & Internet Foreign Offerings: (SEC Rel 7516-when is internet posting not directed to US)
1. If issuer takes appropriate (precautionary) measures that are reasonably designed to ensure that US
persons do not participate in offshore internet offerings then the SEC will not assert jurisdiction
a. Non US issuers offering on internet should:
i. Put prominent disclaimers on their pages stating not being offered in the US (or)
ii. Implement protections to reasonably designed to guard against US participation in the offer
(ie. pwd protect website)
iii. [need good faith compliance by issuer – if issuer does all needed and US fakes ID then not
ruin it unless there is some indication that put issuer on notice that purchaser was US person –
ie check drawn from US bank or gives US taxpayer ID number or SSN]
2. Otherwise posting on web may constitute offer of securities to US

vii. REG S not integrated w/ US offers

viii. US public companies can do REG S and offshore offerings – like MS goes to Germany and offer same
common stock sold here but just to Germans – that is fine – US and Offshore issuers can both use Reg S

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V. SECONDARY OFFERINGS - offerings by underwriters (unlike 1˚ offerings, which are offerings by issuers)
a. Overview:
i. Two groups of people that come under secondary offerings:
1. Holders of restricted securities
2. Control persons (insiders and affiliates)
ii. Definition -Secondary Offering: offering done by someone other than the issuer, but whom still must be
concerned with §5 registration
1. §4(1) underwriters/dealers must register their offerings §5 or seek exemption (144,144A, 4 1 ½, Reg A)
2. The ISSUE is who is an underwriter?
iii. Problems that may occur with underwriters and issuers::
1. If underwriter can’t resale w/o registration thus if issuer relied on exemption & it was resold to out of
state resident or to an unsophisticated person that UW may blow the exemption of issuer b/c integration
a. Once person resells he is underwriter and integration with original exempt offering – blows it

b. Underwriters:
i. Intro –
1. (previous exempt offerings 504,505,506 were not done thru underwriter b/c then would need to register
b/c exemptions were for issuers for most part)
2. if Co wants to do offering they use a middleman – GS, ML who buys securities in bulk from from issuer
and the sells them retail (they are doing an underwriter offering)—Normally register both txn issuer &UW
3. If purchased restricted securities [w/ view to distribute] then you are an Stat. UW. & to sell them need to
register offering or find exemption–this is why those securities are restricted b/c can’t sell them free will
(504,505,506,rule 147)
ii. Statutory Definition:§2(a)(11) The term "underwriter" means 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
participates or has a direct or indirect participation in any such undertaking, or participates or has a
participation in the direct or indirect underwriting of any such undertaking; 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. As used in this paragraph the term "issuer" shall include, in
addition to an issuer, any person directly or indirectly controlling or controlled by the issuer, or any person
under direct or indirect common control with the issuer.
1. UW purchase from issuer with a View To distribution [to the public]:
a. Intent based test. Turns on the state of mind of the purchaser when he bought the securities:
i. Are the shares being acquired with a view to distribution or as an investment?
1. If distribution then you’re an underwriter
ii. Subsequent Actions Test / Rear View Mirror Test: - (since can’t do subjective above)
1. Can only judge what your intent was based on your subsequent actions,
a. Can theoretically change your mind in one day and it is supposed to be intent
based test but no court/SEC will believe you so use these tests.
b. So if sell 2 days after buying securities – even if say changed mind – SEC will
say bought securities for distribution
iii. How long so SEC views purchase as investment and not distribution: Generally 1 year
1. Thus if purchase & sell restricted securities <1 year then distribution and need to
register but if hold onto restricted securities for >1 year then can sell and no longer
registration?
2. Only way SEC believe you and allow restricted security be sold into the market
<1 year and it not be a view to distribution and require registration is if had profound,
unforeseen circumstances, then <1 year resale and still will believe you that when you
bought it you had a view to investment not distribution. (ie kid got cancer and sold <1
Restricted securities also
year SEC ok)
called legendary stock –
can also do escrow of
iv. How can issuer ensure restricted securities are being purchased for investment purposes only:
securities?
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 1. Ask for investment representation letter–use §2a11 lang. & if Stat UW you must
register
2. Place a legend on the physical stock stating securities are not obtained under §5
’33 act so anyone buying or selling them must concern themselves with statutory
underwriter
b. Distribution = distribution to the public [using the RP test (public = unsophisticated investor)]
i. Once the public gets the security distribution is over so can’t be a underwriter if you are the
public purchasing the security and trying to sell the security
c. Examples:
i. Bought shares thru valid §4(2) or REG D & then resold them to ma pa America–You are a
statutory underwriter, which is why the shares were restricted (no diff legally GS or stat UW)
ii. IF MS does registered offering and sells directly to you (an unsophisticated investor and
member of the public) with prospectus etc and then you want to resell it to ma and pa
America – you are not an underwriter, can’t sell w/ a view toward distribution to the public
b/c once you have it distribution is over, your just a secondary trader – so no §5
d. Can have firm commitment UW – GS agrees to buy 1MN shares of MS at 42/share so issuer
gets capital and GS has to sell them; or Best efforts – GS tells MS not committing will only take what I
can sell and there is market for (usually if mkt not strong)

c. Control Persons, Insiders, Affiliates (for our purposes all 3 are same Control Person Insider & Affiliate)
i. §2(a)(11) – last sentence: defines issuer as anyone in direct or indirect control of the issuer [for the purposes
of determining who is an underwriter under §2(a)(11)].
1. Therefore anyone who purchases from a ”control person” is deemed to have purchased from the issuer
and therefore is an underwriter
2. Why do this – b/c avoid abuse of Sec Laws – otherwise CO could sell all their stock to insider a
sophisticated person and then he can sell it to the public – so raise money w/ no registration
ii. Who is a control person?:(Q of fact)
1. Directors and Senior Management are control people
2. Controlling stockholder is considered a control person (Q of fact)
a. Greater than 50% owner is controlling shareholder – per se
b. Dupont 25% GM owner other 75% diffusely held – CT – Dupont is control person;
c. IBank buys 100% stock – then control person – but has no view to distribution – and instead
holds stock for 1 year & then sells it – not need to register that sale b/c not an underwriter (risk to hold)
3. Control person is someone who has the power to compel the issuer to file a registration statement
a. This is a common formulation but is a misnomer – b/c every member of BOD is a control person
even though one director alone may not be able to make compel issuer and make the decision to file
i. Ie if 1 director wants to sell his shares and other 10 on Board say we don’t want to file
registration statement for you right now he is still control person but can’t compel registratin
b. Better test – is whether you are part of a control group.
iii. Implication of control person/insider/affiliate:
1. Control person cant sell securities their securities into the market place w/o registering their offering or
exemption [144, 4(1)(1/2), Reg A? no reg D or 4(2) bc have 4(1)(1/2)
2. If a control person goes out into the public and buys securities that were sold in a registered offering, the
control person still cannot resell these securities w/o registration or an exemption from registration [b/c
only the original offering was registered the securities can’t be registered.
3. Anyone who purchases securities from a control person is deemed to be buying from an issuer §2a11 and
thus is considered to be an underwriter (if have an intent to distribute) so they have to register to resell.
a. THEREFORE – if I buy from an insider w/ a view to distribution or an affiliate sells his shares to
an anonymous market, it is as if the issuer is selling restricted securities b/c it makes any purchaser an
underwriter and this is why control persons can’t just sell their stock at will w/o concerning w/ registrtin

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b. Example: Bill gates–a control person of MSFT wants to sell his shares – he must file registration
b/c Gates is treated as an issuer for §2a11 and therefore anyone who purchases from him w/ a view to
distribution is an underwriter; So anytime gates sells needs to file registration stmt or exemption
c. US v. Wolfson –pg 348 D – insider said technical procedure to register and can’t be bothered
i. Not register is in violation:

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d. RULE 144 (updated) Persons deemed not to be engaged in a distribution and therefore not underwriters
i. Overview: Does double duty –
1. Safe harbor by which control persons (affiliates/insiders) may sell securities to the public w/o registration
a. Both restricted and unrestricted securities
2. Safe harbor under which non-affiliates who hold Restricted Securities (those obtained under §4(2), Reg
D, Reg S) may sell those securities in public w/o registration
a. Q of fact if intent at purchase was investment if so not Stat UW and if mind changes can sell but
since this may be challenged by SEC b/c intent is hard to prove – have rule 144 safe harbor to help
3. Rule 144 has specific criteria if followed then the person is deemed to not be engaged in distribution of
securities and therefore is not an underwriter of the securities and thus can sell securities w/o registration.
4. Rule 144 – is basically made up test to prove that your not an underwriter and intent at purchase was
investment but for control persons even more impt b/c their restrictions never go away due to §2a11 –
making them an issuer for underwriter purposes
ii. Definitions (144a):
1. Affiliate: person who directly or indirectly controls, is controlled by or is under common control with the
issuer. (directors, officers, key employees, and controlling shareholders) – like those from §2a11
2. Restricted securities for 144 include securities issued by: §4(2), 505,506, Reg S; and others
a. 3a11 has own rules for restrictions rule 147 so no 144
3. Debt Security – security that is not equity(equity signifying ownership interest and debt being owed
money but having no ownership interest)
iii. Four types of Transactions for people holding restricted securities --see handout
1. Restricted securities of REPORTING Issuer (public Co. subject to §13&15d of ’34 act):
a. Non-Affiliate for Reporting issuer
i. Non-Affiliate for at least 3 months
ii. No resales for at least 6 months for restricted securities (per se rule)
iii. From 6mos to under 1 year can sell to anyone if the reporting company is current in public
information (all its ’34 act fillings)
iv. After 1 year; all restrictions are gone: the securities are no longer “restricted securities” - so
unlimited public resales under rule 144 & need not comply w/ other 144 reqs (ie be current);
b. Affiliate for Reporting issuer:
i. No resales for 6 mos for restricted securities.
ii. After 6mos may resell in accordance to 144 requirements including:
1. Current public information (’34 act filings)
2. Volume limitations (past 3M no more than >of 1% outstndng or avg weekly vol
of4wk)
3. Equity securities may only be sold in “regular way brokers’ transactions” (so
anonymous) – can’t do private sale to public and use 144
4. Debt securities – have no manner of sale limitations
5. Must file Form 144 (if over 3 mos sell >5000 shares or $50000 aggregate)-simple
frm
iii. No such holding period for non-restricted securities [requirements above still apply]
iv. [Example: If gates buys MS stock on nasdaq – no holding period–can resell at will 144 reqs]
v. [Example: If gates buys §506 MS stock – restricted so can’t resale for 6 mos after-144 reqs]
2. Restricted securities of NON-REPORTING Issuer (private company):
a. Non-Affiliate for non-Reporting issuer
i. Non-Affiliate for at least 3 months
ii. No sales for one year for restricted securities
iii. After 1 year – restrictions are gone – the securities are no longer “restricted” so unlimited
public resales under rule 144 and need not comply with other 144 requirements
b. Affiliate for non-Reporting issuer
i. No resales for one year for restricted securities

35
 ii. After 1 year may resell in accordance with rule 144 requirements including:
1. Current public information 15c211 ’34 disclosure – to get info in public w/o
registration
2. Volume limitations (past 3M no more than >of 1% outstndng or avg weekly vol
of4wk)
3. Equity securities may only be sold in “regular way brokers’ transactions” (so
anonymous) – can’t do private sale to public and use 144
4. Debt securities – have no manner of sale limitations
5. Must file Form 144 (if over 3 mos sell >5000 shares or $50000 aggregate)-simple
frm
iii. No such holding period for non-restricted securities [requirements above still apply]
iv. [Example If Co not have disclosure doc – affiliate can’t sell can’t use 144]
3. SO IF FOLLOW the RULE then your not an underwriter under §2a11 so §4(1) and §5 not apply and
therefore can sell securities w/o registration under §5 [also form 144 is not disclosure]

4. ANALYSIS – if restricted securities – first ask who owns it:

a. If ma pa – ask for how long and see if restrictions are lifted
b. IF control person – restrictions never lifted – have holding period (no resale) and post holding
have 144 requirements:
5. EXAMPLE: Pres buys stock thru NYSE and now wants to sell – Pres still has restrictions b/c 2a11
equates the sale by the control person w/ sale by issuer and there is no such thing as buying registered stck

e. RULE 144A – Private Resales of Securities to Institutions

i. Allows qualified institutional buyers (QIBs) who buys a Reg D securities to sell to other QIBs w/o being
deemed underwriters and therefore w/o registration.(filed on behalf of the underwriter)
1. Qualified Institutional Buyers – an institution with more than $100MN in assets
2. Limitations:
a. The security in question cannot otherwise be a security that is already traded in the public market
i. So if obtain regular MS stock in §506 offering – can’t use this exemption;
b. The issuer must make certain information available to any QIB who asks for it
3. Creates an aftermarket in restricted securities for QIBs – so can purchase w/ intent to distribute w/o
registering as underwriter as per §2(a)(11), which normally is illegal; -also b/c view to distribute is to the
public & QIBs are not distributing to public
4. Example: GE pension fund buys MSFT PFD B thru 506 and next day sells it to AIG; GE not underwriter

f.§4(1)(1/2) Exemptions - Extends non-public offerings to control persons – made up by SEC

i. §4(2) – is limited to issuers and has no reference to affiliates/control persons and 2a11 – says treat as if issuer
– so not really an issuer so can’t use §4(2) as control person or rule 506 – so SEC created 4(1)(1/2)
ii. SO 4(1)(1/2) allows control persons to non-public offering:
1. Requirements:
a. Control person needs to rely on Ralston Purnia by analogy (b/c no safe harbor rule 506)
b. No general solicitation (so not public)
c. Sell to sophisticated investors (RP definition – as to non-public- stnds for sophisticaton)
d. Must have either:
i. Access to issuer information by virtue of position w/in Co (or)
ii. Have been given disclosure
iii. Tacking for Rule 144 – is back to original date of issuance not the 4(1)(1/2) resale date

g. ONLY way control person can sell stock of that firm w/o registration and prospectus is rule 144 or §4(1)(1/2)
i. w/o these if Gates wanted to sell MS stock he must register and provide prospectus
ii. OR can do Reg A but only 1.5MN limit for control persons and Reg A by control is aggregated toward 5MN
for issuer so only 3.5MN left for issuer (if was nonreporting) for 12mos period.
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VI. RECAPITALIZATION, REORGANIZATION, AND ACQUISITIONS
a. Hypos::
i. Coke wants to issue stock dividend to all its Shareholders (MNs people) – does Coke need to register a stock
dividend by the issuer – NO;
ii. Gates gifts $1MN in stocks to Harvard or his son – Must he register this – NO
b. Statutes:
i. §5 states every sale or offer to sell securities must be registered
ii. §2(a)(3) - the term sale or sell shall include every contract of sale or disposition of security or interest in
security for value
iii. §2(a)(3) – the term offer to sell, offer for sale, offer shall include every attempt or offer to dispose of or
solicitation of an offer to buy, a security or interest in a security, for value.
c. FOR VALUE:
i. IF there is no value in a sale, then do not need to register under §5r
ii. To be for Value:
1. The recipient of security made an investment decision; OR
2. Issuer/seller must receive some value (then have a sale/offering)
a. So from giver’s point of view – does he get any value; even if intangible value to Co etc
3. IRS Deductions are held not to be for value – so if donate securities just for deductions – its not for value
under §2(a)(3) and therefore not need registration under §5
iii. Example:
1. Above–Harvard made no investment decision stocks just came & assume no value received by Gates
2. Above – SH made no investment decision to get dividends; (see more below)
d. Free Stock –even though there is no investment decision on part of the recipient of free stock the offering/sale
can still be for value if the distribution creates some benefit for the issuer or insiders (outside tax benefit) and
therefore the free stock distribution may be for value (issuer gets benefit of instant market) and need registration
i. Example dot.com Co gave away 1BN shares for free to any visitors of its website basically an IPO and it was
unregistered offering. SEC said this was illegal – the company giving away free stock were creating an after
market for its securities which was a benefit for the company so subject to §5 and a benefit to insiders who
could then start selling the shares they owned thru say 144 and get money – so incentives to do this

e. Stock Dividends - dividends are a disposition but are not considered value b/c the recipient has made no
investment decision (dividend just shows up) therefore no registration needed;
i. SEC position – the choice between a cash or stock dividend does not involve sale or offer to sell security
despite the fact recipient is making investment decision
ii. A request to change a dividend rate is a sale b/c the buyer is making an investment decision
iii. A dividend reinvestment plan: where stockholder may by prior agreement have their dividend applied toward
the purchase of additional securities from the corporation at current market price (instead of receiving them) is
considered a for value transaction b/c it is a continuous offering& thus subject to registration. (so offer for sale

f.Warrants and Convertible Securities - issue – must you register both the initial issuance of warrant/convertible
security and the security into which it is converted? Is the underlying security for value under §2a3?
i. Immediately Exercisable or Convertible: if the warrant is exercisable or security is convertible
immediately then SEC says that two separate securities are being offered so both must be registered absent an
exemption (or the registration statement must cover both security and underlying security ie. the convertible
security and underlying common stock).
ii. Not Immediately Exercisable or Convertible in the future: if the warrant is not immediately exercisable or
the security is not immediately convertible, then SEC says that the underlying stock does NOT need to be
registered at the time of the offering of the warrant or convertible security;
1. Because there is no immediate investment decision for the investor he can only hold the warrant or
convertible security
2. Once the warrant becomes exercisable or the convertible security becomes convertible, then there must be

37
 an effective registration statement or exemption in place covering the underlying (common) stock because
the holder is now making an investment decision daily (to exercise/convert or hold warrant/convertible)
a. Once up for exercise the old registration statement is no good & at this point have offer do you
want to own the common stock or not and its for value b/c it is an investment decision, which is why
need to have a registration statement which is effective at this future point covering the underlying
security.
b. EVERGREEN – keep prospectus open for entire time conversion option is open, this is done
thru amendments and keeping everything updated b/c only way to do conversion is have effective
registration statement throughout entire conversion time period. (or find exemption)
iii. Convertible security which is automatically converted at some point in future – this does not need a new
registration statement covering the underlying security b/c the investment decision was made when bought the
original convertible security which said will automatically convert in X years – so no investment decision in
the future.

g. Bonds–If there is a vote to make a material change in a bond, even if the change is not passed, there is an
investment decision (whether to accept the change) & therefore a new security is being offered. Therefore the new
security must be registered. [changing the terms of security then must register it as a new offer b/c offer for value]
i. A vote is typically required to change terms of bond and the vote is an investment decision – and therefore is
for value, which is why registration is needed b/c any material change in the bond is seen as offering a new
security. (ie change bond rate b/c Co is going bankrupt otherwise, or change maturity date of bond)
ii. Material change – is if modified in a material respect such that a reasonable investor would think it’s a new
security / material change in the security. [if immaterial change then not make it a new security-no register]

h. Reincorporation (change state of incorporation) and Amendments of Articles of Incorporation:

i. If vote is required then it is an investment decision & disposition is a value transaction requiring registration
ii. HOWEVER, SEC – reincorporation(change state of inc) provided there is no change to securities economic or
voting rights is not sufficiently material to warrant change in security and does not need registration under §5.
1. So even though there is an investment decision – do I want NY or DE corp no registration required
iii. Change in par value – NOT for value b/c no economic consequences to shareholder

i. Spinoffs – Have Company (ie holding company w/ many subsidiary businesses) and wants to get rid of one of the
subsidiaries (one way is asset sale – no registration) but can also do a spinoff, where the parent who is actually just
a SH of the subsidiary gives a stock dividend (subsidiary stock) to each of the parent shareholders pro rata, so that
each parent SH gets same amount of subsidiary shares as he has parent shares. Shareholders before owned shares
in holding company and now own shares in holding company and the subsidiary; SO each Shareholder still owns
the same bundle of rights;
i. SEC sued and lost
ii. Spinoff is not for value – there is no investment decision subsidiary shares just showed up but now there is a
market for the subsidiary shares (but no value to the issuer if he has nothing to do with the stock) and so the
spin off can be used to achieve the same results as a disguised IPO w/o registration.
iii. RESULT: This can be regulated thru the ’34 act – secondary market activity of spun off shares – SEC forbid
brokers from trading stock unless there public disclosure / adequate information in the marketplace

j. Mergers / Acquisitions and Recapitalizations:

i. Intro – For years SEC held there was no value in a stock for stock merger and therefore no offer or sale and
thus no registration under §5. Rule 145 was designed to change this position (so stock for stock needs
registration) but at the same time allow the parties to disclose certain information about the transaction
without violating gun jumping rules.
ii. RULE 145a – sets out the transactions that are subject of the Rule. Any transaction that is not one of those
enumerated is outside the scope of rule 145 and the rule 145 inquiry ends.
1. Rule 145 states each of the following transactions is an offer or sale of a security w/in meaning of §2(a)

38
 (3). (vote of a security holder is required in these transactions).
a. Transactions that are subject to Rule 145 are:
i. A vote taken on reclassification of securities (ie substituting one security for another, but
since it’s the creation of a new security it’s a new investment decision)
1. But not a stock split or change in par value
ii. A vote is taken on mergers (business combination where new securities are exchanged for old
securities – creation of new securities so it is a new investment decision)
1. Exception if merger is just to change state of incorporation – the for value
requirement is not met and Rule 145 does not apply
iii. A vote is taken on transfers of assets involving the issuance of new securities (and involving
new investment decisions)
iii. RULE 145b Information allowed: 145b sets out what may be seen as a safe harbor for what can be said
prior to filing the registration statement (and thus avoiding any problems w/ gun jumping). SEC balance –
concern of communication to the public prior to filing the registration statement while also encouraging free
flow of information to the investing public. The information allowed is similar to that allowed under rule 135:
1. Name of parties: issuer can state its name, name of other parties and a brief description of their businesses
2. Meeting: the issuer can disclose the date, time and place of the meeting to vote on the transaction
3. Description of the transaction: issuer can provide a brief description of the transaction
4. Any other information required by law: issuer can state any other info law requires
iv. Who is underwriter under rule 145c? –once registration is required the question of who may be underwriter
becomes important b/c now there can be said to be a distribution and we know that underwriters must register
their offers and sales §4(1) or find an exemption
1. Rule 145c – all parties to a rule 145 transaction (other than issuer) are underwriters and all affiliates of
parties under rule 145 transaction are underwriters;
a. Example: B merges into A. In the merger shareholders of B receive common stock of A in
“exchange” for their shares of B. Who is an underwriter? Not Company A and its affiliates because the
issuer is not an underwriter(and affiliates of acquirer not receive stock so can’t be underwriters)
according to 145c. If they were parties (company B) to the transaction or affiliates of the parties
(affiliates, insiders, or control persons of company B), they are underwriters and may not offer and sell
without registration or an exemption. Are the former shareholders of B (public stockholders of B, not
affiliates of B), when they receive Company A stock, underwriters with respect to that stock? The
former stockholders of B, provided they are not parties to the transaction (other than the issuer, who is
A) or affiliates of the parties to the transaction, are not underwriters and may sell without registration.
i. We know that when A issued it stock to stockholders of B, that was an “offer” and “sale for
value”, so it was necessary to register when company A offered company A stock to B
stockholders in the merger in exchange for their company B stock.
b. Stockholders of the Parties: stockholders are not normally parties to a merger and are therefore
are not deemed to be underwriters, unless they are affiliates of the parties (usually stockholders of the
acquiror (company A) do not receive stock so affiliates of the acquiror (company A) who do not receive
stock would not be deemed underwriters with respect to the merger)
v. Rule 145(d): Sales by Affiliates: Rule 145(d) gives a safe harbor as to how affiliates of the parties may sell
stock they received in the merger
1. Rule 145(d)(1): the stock received by affiliates of the target (affiliates of B), in the merger may
be resold immediately accordance with the volume and manner of sale limitations of Rule 144:
a. Rule 144(c): there is current information about the acquirer
b. Rule 144(e): the volume limitations of Rule 144
c. Rule 144(f): requiring a broker’s transaction
d. Rule 144(g): defining a broker’s transaction
2. Rule 145(d)(2): if an affiliate of the target (company B) is not also an affiliate of the issuer
(company A) and he has held the stock received (stock of company A) in the merger for at least one year,
that stock may be sold as long as the issuer (company A) is current in its filings under 144(c))

39
 3. Rule 145(d)(3): if the affiliate of the target (company B) is not also an affiliate of the issuer
(company A) at the time of the sale (and has not been an affiliate of Company A for at least three months
prior to a sale) and the stock of the issuer (company A) has been held for at least two years, then the stock
may be freely sold without any consideration of Rule 144 or anything else
a. Notes:
i. If an affiliate of the target (company B) becomes an affiliate of the issuer (company A)
subsequent to the merger, the only requirement of Rule 145 he can rely on for resales of the
stock received in the merger (company A stock) is Rule 145(d)(1).
ii. If such person then leaves company A, he may use Rule 145(d)(2) (assuming that the stock
(company A stock) has been held for one year), even if he ceased being an affiliate of
company A one day prior to the sale,
iii. But he must wait three months after ceasing to be an affiliate of Company A to take
advantage of Rule 145(d)(3) (assuming that the stock has been held for two years).
iv. Remember, if an affiliate of company B never becomes an affiliate of company A, he or she
may immediately resell under 145(d)(1) after a year under Rule 145(d)(2) and after 2 years
under Rule 145(d)(3).
vi. One way to avoid the resale issue entirely for the target is by registering their resales at the same time and
in the same registration statement you use for the registration of the basic merger itself. This is what is often
done. Then any affiliate of Company B may immediately re-sell without worrying about Rule 144(c) and (d)
because their resale offers and sales are already registered. (Remember, that an affiliate must always sell
pursuant to a registration statement or some other exemption, such as Rule 145)

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k. §3(a)(9): EXEMPT TRANSACTIONS; EXCHANGE OFFERS
i. Intro: Shares issued in exchange offer under §3(a)(9) are listed as exempt securities but that is drafting error
this is an exempt transaction [just like §3(a)(11)] and therefore needs no registration or disclosure
1. If structure an exchange in accordance with §3(a)(9); it is exempt from registration under §5 even though
it is an investment decision, which makes it a for value transaction – congress exempted it in §3(a)(9)
a. Example: If offer an existing security holder to exchange his security for another security the
offer of the new security need not be registered. (ie say 12% bond killing issuer want to change it)
2. Issuers usually do 3a9 conversion b/c Co is in trouble and so tries to get some changes in bonds etc
ii. §3(a)(9) Except with respect to security exchange 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; [act does not apply]
1. TEST: IF issuer offers to exchange one security for another w/ its own security holders it is exempt if:
a. The exchange offer has to be done by the issuer; and
b. Exchange offer must be done exclusively [Double exclusivity test]
i. Exclusive with respect to security holders–offer must be exclusively to the issuer’s security
holders: (& only to one security holder ie only bond holder or only stock holder b/c intg)
1. Integration – problem with exclusivity arises if an issuer is doing another
simultaneous offering. If the offers are integrated, then the exclusivity requirement is not
met and the exemption may not be used b/c offers are now made to non security holders
if integrate
a. 5 factor test would not help b/c for 3(a)(9) – need exclusivity? Also if solicit
under 3a9 and integrate with other exempt offer then ruin exemption;
2. Example – if do 3a9 have debenture holder and offer 10 shares pfd stock for
every 1000 debenture; send shares for debenture received – no problem stock need not be
registered
3. Example – if do at same time a simultaneous 506 offering for pfd stock – SEC –
says oferring pfd not exclusively to security –debenture holders and instead also offering
to public under 506 so no 3a9 – violate exclusivity
ii. Exclusively Security for Security - there cannot be any other consideration for the security
being exchanged (no boot) – just security for security;
1. Issuer cannot even pay for legal or tax advice for the holder in connection with
the exchange, it is new consideration and exclusivity requirement is blown
2. Sales Commission – cannot be paid in connection with exchange (exclusivity
ruined)
3. Example – can’t offer bond holder 10 shares common stock plus $10 in
exchange for its 1000 debenture b/c have additional consideration that’s not security – so
no 3a9;
c. Good faith requirement: SEC reads in 3rd prong–a good faith business purpose for the transaction;
2. Convertible Securities: the standard conversion feature of a security when exercised can be exchanged
under §3(a)(9) so the conversion is exempt;
a. Provided security is not immediately convertible–then offering 2 securities and need register both
3. Character or Exchanged Securities: the character of security received in a §3(a)(9) exchange is the
same as the one given up (ie if give up restricted security then receive a restricted security in return and if
you’re an underwriter if sold first security then underwriter in sale of second security)
4. Resales of §3(a)(9) securities – since the exemption is only available to the issuser, the exchanging
security holder must find his own exemption for any subsequent sale of security received in the exempted
exchange
a. Tacking – is generally available to help the holder in meeting the appropriate holding period (ie 1
year holding period for 144)

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VII. EXEMPT SECURITIES – (no registration under 5)
a. Intro – Exempt securities are securities but are still exempt from §5 – the nature of the security itself rather than
the manner of the transaction makes these securities exempt. Since they are exempt no registration is required.
i. §3 is called exempt securities but has both exempt transactions (3a9, 3a11, 3b(504,505,regA)) rest of §3a
are exempt securities:

b. 3(a)(2) – Government Securities, Bank Securities and Collective, Common, or Single Trust Funds
i. Government Securities (Bonds) – securities issued or guaranteed by the govt These are exempt b/c the
theory is governmental bodies should not regulate each other.
1. IF IRS determines bonds interest is tax exempt then the securities are exempt from §5 registration;
ii. 2 types of Government bonds
1. General Obligation Bonds – are exempt and GOs are backed by the full faith and credit of the issuing
government entity; GOs can be issued by Federal, State and Local governments;
a. US treasury backs US bonds can print money; NY state bonds backed by state and tax to get $$
b. NO disclosure requirements –no registration under §5;
i. But ’34 15c2-12: if UW of municipal offering >1MN need official stmnt (disclosure doc)
from issuer and make the document available to any prospective purchaser; except in
competitive UW bids;;
2. Other types: Industrial Development Bonds (IBDs), mini bonds
a. IBD bonds – Gov’t (fed, state, local) allows IBDs to be issued to raise money for public works
projects and are backed by revenue of the project (sewers, dams, highways);(ie like NY sewer authority)
i. TO encourage these projects and allow raise money at a lower interest rate – these bonds can
be issued tax exempt from the authority; b/c if tax exempt then the interest rate is that of
equivalent corp bond less the marginal tax rate – so authorities pay lower interest
ii. BUT have no full faith and credit of US – and money coming in may not be enough – so
there are default risks;
b. FOR IBD bonds to be Exempt securities from §5:
i. Bonds are Tax Free: IRS grants tax exempt status – so securities laws do not make the
decision of whether to exempt bonds/securities from §5 registration; IRS has lots regs on it
1. ie – IRS req- Meet social public good requirement;
ii. Disclosure statement must be given to investors (issuer not bound by disclosure – but the
underwriter is – see above)
iii. Bank Securities: §3(a)(2) – exempts any security issued or guaranteed by a bank, including foreign banks
with US branches; [better regulatory authority]
iv. Trust Funds – interests in common trust funds maintained by banks are exempt securities under §3(a)(2);
banks must exercise “substantial investment responsibility and trust funds must not be sued as a vehicle for
general investment by the public
1. Pension funds –

c. §3(a)(3) – Short Term Notes (Commercial Paper Exemption) 9mos test

i. §3(a)(3) exempts any note, draft, bill of exchange, banker’s acceptance which arises out of a current
transaction or the proceeds of which have been or are to be used for current transactions and which has a
maturity at time of issuance not exceeding nine months, exclusive of days of grace, or any renewal thereof the
maturity of which is likewise limited
ii. Commercial paper exemption – is for “prime quality negotiable commercial paper of a type not ordinarily
purchased by the general public”
iii. These notes are used by large companies to borrow for short terms to cover debts; basically the big players –
do this as overnight money; (ie GE has 100MN cash so puts in Bank MS needs 100MN for next day payroll so
borrows and then few days later MS gets earnings and pays off bank) – Bank rate is the Fed overnight rate?
1. Has nothing to do w/ commercial notes & Reves (which have maturity for 1 yr.; &used to by ma/pa)
iv. REQUIREMENTS:
42
 1. Current transaction–proceeds must be used to fund current transactions; this covers assets easily
convertible into cash & comparable to liquid inventories of an industrial or mercantile Co. SEC lenient;
2. Nine months Maturity – commercial paper can’t have a maturity that exceeds 9mos;
a. Securities w/ automatic rollovers may jeopardize the exemption
3. Prime Quality – Issuer must have the highest short term rating by recognized rating agencies
a. Rating is of short term debt not the issuer;
4. Manner of offering – commercial paper exemption is limited to securities not ordinarily purchased by
the general public – this is enforced by requiring commercial paper to be issued only in large
denominations prohibiting general solicitation and requiring investor sophistication;
v. This is not family resemblance test of Reves for commercial notes to run business – buy A/R, inventory
etc – which is a judicial developed test.

d. §3(a)(4) Non-Profit Issuers:

i. §3(a)(4) - exempt security issued by person organized and operated exclusively for religious, educational,
benevolent, fraternal, charitable, or reformatory purposes and not for pecuniary profit and no part of the net
earnings of which inures to the benefit of any person, private stockholders or individuals or security of a fund
that is excluded from the definition of investment company
1. Issuers must also have IRS exemption:
2. This includes: Knights of Columbus, Churches; So they can issue notes to anyone and put ads in WSJ all
w/o registration b/c exempt securities;

e. 3(a)(5): Highly Regulated Industries – securities issued by a savings and loan association or building and loan
association, Coops, homestead assoc.; [institutions that are supervised and examined by state or federal authorities]
i. Applies to any security issued by a savings and loan association which is supervised by the federal or state
government (rationale is that S&L’s have their own regulatory system)
f. 3(a)(6): Interests Railroad Equipment Trust. In 1933, the railroad industry was the most powerful industry,
therefore, railroad equipment is exempt. – pure lobbying
g. 3(a)(7): Bankruptcy Exemption. Applies to securities issued by a receiver or by a trustee or debtor in
possession under federal bankruptcy law (rationale is that the bankruptcy court protects this).
h. 3(a)(8): Insurance Policies and Annuities. (endowment policies) Are exempt because subject to supervision
insurance Cos. are already heavily regulated. By insurance commissioner, or bank commissioner etc;
i.3(a)(12): Bank Holding Companies. Exempts shares issued by a bank holding company

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VIII. Liability Under the 33’ Act – (investor rights not provided by common law)
a. ’33 Act is a consumer protection act – and does so thru disclosure but if fraud there are liabilities:
b. PRIOR to ’33 Act: if wanted to sue for Securities Fraud only relief for P was CL tort of fraud which required:
i. Misstatement / fraud
ii. Scienter (intent to commit fraud)
iii. Causation
iv. Privity (P is in privity w/ D – no fraud thru hearsay)
v. Reliance (reliance on the fraud/misstatement to your detriment)
vi. Damages
c. P had to prove each of these elements prior to the ‘33 act but the act made an action for securities fraud easier;

d. Section 11 – Civil Liabilities on Account of False Registration Statement; [pg 22 of act]

i. Intro – only for material misstatements in the registration statement -
ii. §11(a) in case an part of the registration statement, when such part became effective, contained an untrue
statement of a material fact or omitted to state a material fact required to be stated therein or necessary to
make the statements therein not misleading, any person acquiring such security (unless it is proved that at the
time of such acquisition he knew of such untruth or omission) may, either at law or in equity…sue…
1. Material misleading misrepresentation or omission in registration statement will subject the issuer
(subject to any due diligence defenses) & a variety of persons associated with the issuer or the distribution
to damages in suit brought by any person who bought the securities pursuant to the registration statement;
2. DO NOT NEED TO SHOW causation, scienter, or reliance;(just need material misstatement or
omission; damages & privity) but do not need to have acquired the security from the issuer; any person
who acquires the securities can sue as long as comes thru a direct chain from initial offering.
iii. KEY to §11 is deterrence so if client loses $ then get prospectus & look for material misstatement/omissions
iv. Analysis: (§11(a))
1. Limitations:
a. by definition §11 is available only for registered public offerings:
i. So not available for 3a9, 3a11, 3b, 4(2), Reg D, Reg A, Reg S, 506?
b. Can only sue when the registration statement b/m effective (no suit for preliminary prospectus)
i. So can’t sue for material misstatements or omissions in the preliminary prospectus;
2. Standard: any “untrue statement of material fact or omitted to state a material fact”
a. This is the only thing to prove for P – that there is material misstatement or material omission
i. so if say warehouse is 10000 sq ft but is really 9980 sq ft – no case
3. Privity – is required but the security not have to be acquired from the issuer – any person acquiring
security can sue so long as shares purchased came through a direct chain from the initial offering (ie if
bought in secondary market) – SO daisy chain is permitted; corporation cannot indemnify D/O for §11
violations
4. NO need to show reliance on the material misstatement or omission; ok if never read prospectus &buys
5. NO need to show causation – of damages by material the misstatement or omission
6. NO need to show scienter – that the issuer intended to defraud (unlike 10b-5)

7. Who May Sue: (P limitations):

a. Tracing Requirements: Any Plaintiff can sue but P must show that the securities bought were
pursuant to the registration statement at issue; (daisy chain privity)
i. Example – if 97% of outstanding securities were pursuant to faulty registration statement, P
can’t just do statistical analysis and assume he had shares pursuant to faulty registration
statement – he must trace the security;
b. If Plaintiff knew the statement was untrue or had omission – then he can’t sue
i. “unless it is proved that at time of such acquisition he knew of such untruth or omission”

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 8. Who may be sued: [each of them can be sued Personally]
a. Issuer itself has no defenses [assuming misstatement cause stock drop if else cause drop no recy]
b. Signatories to the registration statement – Every person who signed the registration statement
i. ie the issuer (b/c person is term of art), President, CEO, CFO, directors, comptrollers
ii. Each person is personally liable
c. Directors of or Partners in the Issuer at the time of filing: every person who was director of
(or person performing similar functions) or partner in the issuer at time of the filing of the part of thre
registration statement to which liability is asserted
i. Sue these people personally even though they didn’t sign the registration statement;
d. Imminent Directors of the Issuer: every person who w/ his consent, is named in the registration
statement as being or about to become director, person performing similar function, or partner
i. Sue personally even though didn’t sign registration statement;
e. Experts named in the registration statement; (ie accountants, engineers, appraisers) any expert
who, with his consent, has been named as prepared or certified any part of the registration statement;
i. Prospectus have expertisized sections – need experts so others can value company – ie if oil
and gas company need expert to do studies and determine how much oil is underground – the
more oil the more valuable the company; or Art Co – need expert to value inventory so can
then determine value of company
ii. Lawyers are not considered experts unless issue a report on a legal issue such as complex
litigation or antitrust and only liable for that part
iii. Experts are personally liable for the portion of the registration statement attributed to them
(the section they expertise) and not for the rest of the registration statement
1. If material error w/ expert section can sue him. Expert signs off on his sectn of
prospectus so if issuer put 10 & it is supposed to be 100 oil expert liable b/c signed off on
his section
f. Underwriters: every underwriter with respect to such security involved in the distribution
i. Underwriters can be personally sued. Therefore they must take an interest in what they are
underwriting [this is another section like 3a11 that almost broke the 33 act from passing]
ii. This means if any prospectus errors underwriter is liable – any underwriter both commercial
and statutory underwriter
iii. BUT NOT want underwriters to be personal guarantors of the issuer – since everyone will sue
the deep pockets – have §11(b)
v. §11b - Escaping Liability (due diligence/ whistleblower/ director unaware of effective registration)
1. Intro – sec 11a is harsh – makes underwriter personal guarantor, and outside directors liable and experts,
if material misstatement but what if did all their procedures right? So have 11b;
2. §11(b) “no person other than the issuer shall be liable as provided therein who shall sustain the burden of
proof”
a. Issuer is subject to strict liability for a material misstatement or omission of fact; per se liability –
i. Issuer is liabile for the entire registration statement and has absolute liability even if it was a
good faith mistake or typo; issuer is still liable
b. Due Diligence Defense (never appears in section?): is available for all but issuer & is absolute
defense: even if you’re wrong
i. No person other than the issuer, shall be liable who “had after reasonable investigation,
reasonable grounds to believe and did believe, at the time such part of the registration
statement became effective, that the statements therein were true and that there was no
omission to state a material fact required to be stated” §11b3
1. Though doesn’t say due diligence that is what reasonable investigation is;
2. Have to show did everything you could to ensure the registration statement
wasn’t faulty
a. Document all due diligence like reports, interviews, calls etc – create a report
ii. WHAT IS Reasonable investigation? Q of fact?
45
3. §11(c) Standard for due diligence: How much do you have to do ?
a. §11(c) – “in determining…what constitutes reasonable investigation and reasonable grounds for
belief, the standard of reasonableness shall be that required of a prudent man in the management of his
own property”
b. For Experts: - Experts are held to the industry standard.
i. If expert meets the industry standard and still gets it materially wrong – he is not liablie b/c
he did his due diligence (reasonable investigation) and that is an absolute defense
1. Keep a log of how followed industry standards
ii. An objective standard of a reasonable person standard of their profession
1. ie what would a reasonable geologist do? – get experts of industry to testify as to
industry standards – like deans of schools or heads of organizations;
c. Reliance on Experts: everyone but issuer can rely on the expert information. Need to be sure to
hire a reputable expert in order to rely on the experts section
i. And if there is a mistake in the expert section can still rely on the experts information w/o
further do diligence; but if not reputable expert then others can’t rely on expert info w/o
doing future investigation
ii. NOT valid due diligence defense that left it up to the lawyers (relied on lawyers)- Kern
d. Standard of Care for all others liable: Due diligence is a Sliding Scale subjective test
i. The more knowledge you are presumed to have the higher the standards you are held to:
1. To much is given much is expected;
ii. Escott v. BarChris – fleshes out the standard of care, court said the standard of care is not
applied uniformly. Instead look at each defendant and ask “what reasonable care would I
expect from that person” Therefore due diligence is a sliding scale – subjective test;
iii. Outside directors need to make reasonable investigation to the best of their capabilities given
their knowledge and experience in the industry;
iv. Each person will have to meet the due diligence standard based upon their position, expertise
and function in the company (BarChris)
v. Example:
1. Plastic Co has directors preparing prospectus once is Chemistry prof, other is
travel agent; both as directors need to do due diligence and ask questions and investigate
– but more is expected from the Professor when visits the plant and asks questions of
experts, which travel agent did not know
2. 2 directors – VP marketing and VP production – there is a widget production
problem not mentioned in prospectus – Markeitng says I asked VP production and some
engineers and none said problem – this is probably enough for his due diligence but
Production just asking engineer is not enough – he is responsible for plant activity and
higher stnd; VS. if 2 weeks after reg stmt which says have sales tied up for next 5 years a
40% customer pulls his sales stk plummets– now VP marketing higher stnd he lives to
serve clients and should know about his biggest client – has higher burden to satisfy
compared to VP production here;
vi. BUT REMEMBER all directors are responsible for not just their section but for all – so need
to keep due diligence folder on all activities, all people called, questions asked etc – just be
held to higher stnd for your section or area that you know more about but still need to due
diligence/reasonable investigation on all of it; can’t just close your eyes as to the rest;
4. SO this is why underwriters are not guarantors they have to conduct due diligence (show did
everything they could to investigate the Co’s info as accurate) and if do so then not liable;

5. RULE 176-Circumstances affecting the determination of what Constitutes Reasonable investigation

& Reasonable grounds for Belief under §11 of the Sec. Act–Just provides sliding scale factor
a. In determining whether or not the conduct of a person constitutes reasonable investigation or a
reasonable ground for belief meeting the standard set forth in section 11(c). Relevant circumstances

46
 include, with respect to a person other than the issuer:
i. The type of issuer [Does the person have expertise in that area]
ii. The type of security
iii. The type of person
iv. The office held when the person is an officer
v. The presence or absence of another relationship to the issuer when the person is a director or
proposed director.
vi. Reasonable reliance on officers, employees, and others whose duties should have given them
knowledge of the particular facts
1. in light of the fxns & responsibilities of the particular person wrt the issuer & the
filing
vii. When the person is an underwriter, the type of underwriting arrangement, the role of the
particular person as an underwriter & the availability of information wrt the registrant;
viii. Whether wrt a fact or document incorporated by reference, the particular person had any
responsibility for the fact or doc. at the time of the filing from which it was incorporated.
6. §11(b)(1) -WhistleBlower Defense: a director can escape liability if before the effective date of the part
of the registration statement with respect to which his liability is asserted, he 1. Resigned (or taken steps
permitted by law to resign) and 2. He advised the SEC and the issuer in writing that he had taken such
action and that he would not be responsible for that part of the registration statement;

7. §11(b)(2) Director did not know the registration became effective: escape liability if such part of the
registration statement became effective without his knowledge, upon becoming aware of such fact, he
acted and advised the SEC in accordance with §11b1 (above), and in addition, gave reasonable public
notice that such part of the registration statement had become effective without his knowledge

vi. §11(f) – Joint and Several Liability – for most §11 defendants, there is joint and several liability. “all or any
one or more of the persons specified in subsection (a) shall be jointly and severally liable, and every person
who becomes liable to make any payment under this section may recover contribution as in cases of contract
from any person, who if sued separately, would have been liable to make the same payment, unless the person
who has become liable was, and the other was not, guilty of fraudulent misrepresentation”
1. Each D responsible for 100% dmgs can sue anyone for full amount & D’s can then deal w/ contribution
2. Liability for Outside Directors (11(2A)): liability for outside directors in the absence of knowing
misconduct is proportionate (contributory) as opposed to joint & several.
a. So Proportional liability to their negligence on due diligence
b. Otherwise impossible to get outside directors – SEC likes outside directors –so only proportionate
3. Underwriter liability – may not exceed the total price at which the securities written by him and
distributed to the public were offered at to the public (see damages 11e) but with J&S can get 100% liablty
vii. Indemnification – issuers may not indemnify any persons liable under §11 (against public policy – Globus)
but the issuer may purchase D&O liability insurance that indemnifies directors from §11 liability

viii. Damages under §11: [can’t exceed offering and is difference in amt paid and resale price/value at suit]
1. §11(e) – P may recover damages equal to the difference between:
a. the amount paid for the security; and
i. (not exceeding the price at which the security was offered to the public)
b. the value of the stock as of the time of the suit was brought; or
c. the price at which the security shall have been disposed of in the market before the suit; or
d. the price at which the security shall have been disposed of after the suit but before the judgment if
such damages shall be less than the damages representing the difference between the amount paid for
the security(not exceeding the price at which the security was offered to the public) and the value
thereof as of the time of such suit was brought;
2. §11(g) Upperlimit: in no case shall the amount recoverable under this section exceed the price at which
47
 the security was offered to the public
a. So the upper limit of damages is the amount the issuer sold the security for
b. For underwriter the amount the underwriter bought and sold it for
c. Example: stock offered at $10, peaked to $80 where some P’s bought etc, then fell to $9
i. The max amount recoverable is $1; & What if fell to $11; no recovery;
3. §11(e) – Negative Causation–“if the defendant proves that any portion or all of such damages represents
other than the depreciation in value of such security resulting from such part of the registration statement,
with respect to which his liability is asserts…such portion of or all such damages shall not be recoverable”
a. So if D proves stock price declined for reasons other than material misstatement or material
omission (faulty registration), then the portion not attributed to faulty registration is not recoverable – so
portion that went down anyway can’t be recovered
i. judge determines what portion of drop caused by extraneous circumstances
b. Thus causation need not be proved by P to recover but D can use causation as a defense;
i. Hypo: Stock offered at 10, now $1; dmgs is $9; but if D proves Dow went down 30% $6 is
attributable to the misstatement; so only liable for that;
4. Need Privity – P has to prove that the security he lost money on came from the registration statement
with the mistatment – (see above) – daisy chain privity is allowed – do not need to have P buy from issuer;
a. So if P bought from C, who bought from B, who bought from Issuer –
i. & misstatement comes out when P has security – he can sue issuer –as long as can trace back
ii. w/ computers–easier to trace that same stock certificate all the way back to specific registratin
iii. SO if bought in open market can’t sue unless shares were the ones issued from that
registration statement w/ misstatement –
iv. SO if public co shares trading for long time – hard to trace to particular registration but if IPO
all securities came form the registration statement – so easier to trace and find privity –
ix. Statute of limitations : SOX extended SOL to no more than 3 years after the fraud was discovered and 5
years after the fraud took place (from 1yr and 3yrs respectively) §13
x. Burden of Proof: if issuer publishes earnings statements generally covering the 12 mos period after
registration , the burden of proof shifts and the investor must show he relied on the material misstatement;

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e. §12 – Civil Liabilities arising in connection with Prospectus and Communications:
i. Intro: This is a recessionary statute therefore only recover consideration paid – give up the security and get
your money back; (undo the tranasaction)
1. Sec 11 – was for faulty registration statement (but still was registered offering)
2. Sec 12–is for those that didn’t’ register their offering but should have, which includes a blown exemption;
ii. §12(a)(1) [failed to register] “any person who offers or sells a security in violation of section 5 shall be liable
subject to subsection (b) to the person purchasing such security from him, who may sue…to recover the
consideration paid for such security with interest thereon, less the amount of any income received thereon,
upon the tender of such security or for damages if he no longer owns the security
1. Direct privity required – only direct purchasers from issuer may sue
a. Says “sells” is liable so that is why need privity with buyer –
i. So only direct purchaser can sue issuer underwriter or dealer for not registering;
b. (Pinter v. Dahl–only those in direct privity w/ buyer can be liable)
c. Also need show that the stock they have was the one attached to the violation;
2. Strict liability provision for §12(a)(1) – (no scienter, causation, no due diligence defense)
3. Damages: Recessionary statute –
a. if still own security–get consideration paid in original transaction + interest (less income received
b. If P disposed of security – get recessionary damages
i. Difference btwn price paid and amount received on subsequent sale (and income received)
c. GOAL – put you in position as if transaction never happened;
4. Examples of 12(a)(1) violations: Failed Reg D, 4(2), 3a11 offerings or failed 3a9 exchange;

iii. §12(a)(2) [misstatement in prospectus or oral communication] any person who offers or sells a security
(whether or not exempted…) by use of any means or instruments of transportation or communication in
interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an
untrue statement of a material fact or omits to state a material fact necessary in order to make the statements,
in light of the circumstances under which they were made, not misleading (the purchaser not knowing of such
untruth or omission) and who shall not sustain the burden of proof that he did not know and in exercise of
reasonable care could not have known of such untruth shall be liable subject to subsection b to the person
purchasing such security from him, who may … to recover the consideration paid for such security with
interest thereon, less the amount of any income received thereon, upon the tender of such security, or for
damages if he no longer owns the security
1. Intro: This same thing as §11, in terms of faulty registration b/c prospectus is big part of registration –
but unlike §11 – §12 has recession instead of damages & §12 offer issuer due diligence defense;
a. §12a2 should’ve been for Unregistered offerings–especially b/c those are hard to value so give
them their $$ back but b/c of bad reading of statute by Gustafson–§12 only applies to registered offering
b. Therefore only remedy for unregistered offerings (like nonpublic offering) is in the ’34 act
2. §12(a)(2) – Offer or Sell – using prospectus or oral communications which have untrue statements of
material fact or omission of material fact& didn’t prove that in doing due diligence he couldn’t have knwn
3. Limiting 12(a)(2) – Gustafson v. Alloyd Co. and the meaning of prospectus
a. No where in §12(a)(2) is a mention of registration statement it only discusses prospectus therefore
one would think that §11 is for registered offerings w/ faulty registration statements and §12 is for
unregistered offerings w/ bad communications/prospectus – BUT Gustafon ruled that §12(a)(2) only
relates to registered offerings since prospectus only appears in context of registered offerings ct says; 33
Act has nothing to do with secondary markets ONLY applies to ISSUERS and UNDERWRITERS (so
SCOTUS logic makes no sense)
i. Gustafson v. Alloyd Co – P sued under §12(a)(2) for material misstatement in a disclosure
document in a private placement (couldn’t sue under §11 b/c only for registration stmnts). P
relied on the broad definition of prospectus under §2(a)(10); The SCOTUS said b/c the term
prospectus only appears in the context of a registration statement that 12(a)(2) is available
only for registered offerings and that there is no liability under §12(a)(2) for fraudulent
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 disclosure documents other than prospectus in a registered offering;
1. Dissent(Thomas) relies on broad prospectus definition to cover this;rrr
4. §12(a)(2) Due Diligence Defenses: available to anyone who offers or sells a security- including issuer;;
a. Even the issuer can use due diligence defense (unlike §11 and §12(a)(1));
5. Remedy – is recession – (see above)
6. §12(b) Loss Causation – if in §12(a)(2) – D can prove negative causation (causation defense) –stock
went down for another reason other than misstatement & than that portion is not recoverable –
a. But makes no sense b/c it is Recessionary statute so get your money back – so 12b has no
meaning right now

iv. Statute of limitations : SOX extended SOL to no more than 3 years after the fraud was discovered and 5
years after the fraud took place

f.§14 Contrary stipulations void – any condition, stipulation, or provision binding any person acquiring any
security to waive compliance with any provision of this title or of the rules and regulations of SEC shall be void
i. SO can’t waive rights of ’33 act

g. §15 – Liability of controlling persons:

i. Control person – Every person who controls any person is liable under §11 or §12 is also liable jointly and
severally with and to the same extent as such controlled person to any person to whom such controlled person
is liable (Q of fact if person is controlling person)
1. This prevents people from hiding behind straw persons and let the straw get the blame for wrong doings –
and congress wanted to avoid setting up dummy corps and judgment proof corps
2. There is a due diligence defense for controlling persons (no knowledge of wrong and did their reasonable
investigation)

h. §17 Fraudulent interstate transactions –“It shall be unlawful for any person in the offer or sale of any
securities…by the use of any means or instruments of transportation or communication in interstate commerce or
by use of the mails, directly or indirectly 1. to employ any device, scheme or artifice to defraud; 2. To obtain money
or property by means of any untrue statement of material fact or any omission to state a material fact…; 3. To
engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon
the purchaser”
i. §17 offers no private right of action –
1. only SEC can bring action under §17;
2. Vs section 11 and 12 – SEC not use b/c they are for damages – so private actions; rr
ii. Very broad language SEC can do whatever it wants
iii. “unlawful” term of art so means criminal liability – can go to jail or fines under §17;

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IX. SECURITITES EXCHANGE ACT OF 1934 (aka ’34 act aka Exchange act)
a. Overview: the ’33 act is a consumer protection statute – disclosures from issuers (1˚&2˚ offerings); The ’34 Act
is a regulatory statute that concerns secondary trading. It provides a comprehensive regulatory structure for the
securities industry (exchanges, broker-dealers, public companies, insiders, tender offers etc) and Created the SEC.

b. §2 – Necessity for Regulation – “…transactions in securities as commonly conducted upon securities exchanges
and over-the-counter markets are affected with a national public interest which makes it necessary to provide for
regulation and control of such transactions … and matters related… including transactions by officers, directors,
and principal security holders, to require appropriate reports, to remove impediments to and perfect the mechanisms
of a national market system for securities … and the safeguarding of securities and funds …, and to impose
requirements necessary to make such regulation and control reasonably complete and effective, in order to protect
interstate commerce, the national credit, the Federal taxing power, to protect and make more effective the national
banking system & Federal Reserve System, & to insure the maintenance of fair & honest markets in such txns”
i. §2(4) - National emergencies, which produce widespread unemployment and the dislocation of trade,
transportation, and industry, and which burden interstate commerce and adversely affect the general welfare,
are precipitated, intensified, and prolonged by manipulation and sudden and unreasonable fluctuations of
security prices and by excessive speculation on such exchanges and markets, and to meet such emergencies
the Federal Government is put to such great expense as to burden the national credit
ii. Thus – Securities market involves national public interest; lots of fighting about this power but SCOTUS
upheld it – so have power to regulate;

c. §3 – Definitions and Applications;

d. §4 – Securities and Exchange Commission:“There is hereby established a Securities and Exchange Commission
…to be composed of five commissioners to be appointed by the President … and consent of the Senate. Not more
than three of such commissioners shall be members of the same political party, and in making appointments
members of different political parties shall be appointed alternately as nearly as may be practicable…Each
commissioner shall hold office for a term of five year
i. Created SEC and Attempt to depublicize SEC, no more than 3 from party so if D pres and have 3 Ds then
have to appoint R; Commissioners have staggered terms and one is a chairman;
ii. SEC enforces securities laws

e. §5 – Transactions on Unregistered Exchanges – “It shall be unlawful for any broker, dealer, or exchange, …
for the purpose of using any facility of an exchange within or subject to the jurisdiction of the US to effect any
transaction in a security, or to report any such transaction, unless such exchange (1) is registered as a national
securities exchange under §6, or (2) is exempted from such registration upon application by the exchange b/c, in the
opinion of the SEC, by reason of the limited volume of transactions effected on such exchange, it is not practicable
and not necessary or appropriate in the public interest or for the protection of investors to require such registration.”
i. Exchanges must be registered with the SEC (and with registration comes regulation) or find exemption
1. So NYSE went from totally private to super regulated (to minute details like NYSE had fractional bids
and SEC wanted it decimals so changed it)
2. Internet – is why really need this now – b/c say want to sell your GM stock – why not just eBay it not
have to worry about commissions etc so cheaper, and they tried running internet trading – which was not
open to any insiders of the company but SEC shut it down said securities market is one of national interest
so we can regulate it – SO no exchange unless register with SEC; [no cyberexchange]
ii. Unlawful for broker/dealer etc to trade unless exchange is registered;

f.§6 – National Securities Exchanges – registration of an exchange w/ the SEC under this section – and
requirements for exchange to be registered; Illegal in this country to operate a securities exchange w/out registering
the exchange with the SEC  changes everything (power to require registration is inherently the power to regulate;
unless you operate this way, I’ll withdraw your registration)
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g. §7 – Margin Requirements –this is the only section of the securities laws which is not regulated by the SEC and
instead is regulated by the Federal Reserve Bank –
i. Regulates trading on margin – by setting minimum equity requirements (ie can’t borrow more than 50% of
the value of the stock) – There are rules as to how and when you can trade on margin
ii. Purpose is to keep people from buying stock who do not have an equity interest in that stock
iii. What is Margin: (Margin - basically borrowed money; Leverage – abilty to use borrowed money to make or
lose money; margin call – broker asks for more equity b/c below the margin (equity requirements))
1. HYPO – Want to buy 1000 shares $1/share but only have $100 – go to broker and give him 100 and ask
for loan for 900 and so have $1000 to buy 1000 shares; Broker is ok w/ it b/c loan is secured – have the
shares and if you don’t pay back he can just sell the shares; [$100 is equity in deal; $900 is margin]
a. IF stock goes to 2 dollars then can sell your stock get your 100 dollars pay back the 900 to the
broker and get 1000 in profit; leverage can dramatically increase earnings;
b. If stock goes down to 1 dollar – have 100 in equity and 900 in margin and still 1000 value for
stock – so if you walk away broker can still sell your holding and get his money
c. If stock goes down to $0.70 per share – now the 1000 shares only worth 700 so if you skip town –
broker is out 200 even if he sells entire position – So if this occurs – Broker does Margin Call – for 200
dollars so have a total of 900 dollars in account when add equity and share value; if investor does not
have the money – the broker is screwed – will have to cut their losses and sell your position (panic sell);
2. Snowball–if market is tanking then there are lots of margin calls b/c stock value is down but if investors
not follow the margin call the brokers are screwed and sell the investors holdings to cut their losses- but by
selling stock the market goes lower and have even more margin calls b/c stock worth even less;
a. Background – Stock market crash of 1929 – the market was highly leveraged – lots of stock
bought on credit and then margin call snowballs – every one sell more margin calls crash – and bank
failures b/c all these people bought on credit – SO Congress thought buying on credit bad;
iv. So federal reserve now sets margin rates and it varies – right now is 50%; - so limits how much you can
leverage yourself and prevents panic selling by giving breathing room – so if 100 dollar investment can only
get 100 dollars in margin – so 200 total investment and now if stock starts to fall – lots of room for broker to
get his 50 dollars back; ----- SO at can only double your investment – right now;

h. §9 Manipulation of Security Prices – “It shall be unlawful for any person, directly or indirectly… For the
purpose of creating a false or misleading appearance of active trading in any security … or a false or misleading
appearance with respect to the market for any such security, (A) to effect any transaction in such security which
involves no change in the beneficial ownership thereof, …”
i. Purpose –to prevent use of the market to manipulate the price of a stock by requiring all trades to be at arms
length & fair so the price of the stock reflects its FMV – what willing buyer & seller agree to in good faith;
ii. No wash sales: 2 parties/brokers trade a thinly traded security back and forth so then drives up price and
other investors will see and jump in and then the 2 brokers will get out at a high price and stock will fall b/c
there is nothing to support the rise; (false active trading not allowed)
iii. Criminal liability to manipulate the price of a security

i. §10 – manipulative and deceptive devices – Anti fraud statute - See below

j. §11 trading by members of exchanges, brokers, dealers – can’t trade on own account only take orders from
customers – b/c need to get best price etc for them – own trading creates conflict of interest
i. For brokers to trade on own acct need to use third party broker –

k. §12 –Registration Requirement for Securities – this section creates a public company (reporting company) –
for ’34 act need to register securities (but has nothing to do with §5 of ’33 act and registration of the offering) –SEC
regulates secondary trading thru the ’34 act – one way is to register exchanges under §6; other is register securities
and now can regulate those securities (ie require disclosure etc)
52
 i. To become a public company need to have at least one class of securities registered under §12;
ii. §12(a) – General Requirement of Registration – “It shall be unlawful for any member, broker, 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”
1. Before a class of securities can be traded on any exchange; the securities must be registered under §12b
2. IF issuer registers a class under §12(b) of the ’34 act – then he is a reporting/public company and must
comply with the disclosure requirements of the ’34 act;
3. Registration is voluntary only if issuer wants his securities traded on exchange (adds liquidity) unless
§12g
iii. §12g – Mandatory Registration – If an issuer has net assets of $10MN or more AND 500 or more
Shareholders for a given class – then issuer must register that class of stock under §12, whether or not
securities are traded (publically) – b/c this section is about reporting companies (public co is not proper term)
1. File form 10 or registration statement
iv. §15d – any issuer who registers an offering under ’33 act must register that class of securities for the year of
the offering and the following year – even if don’t’ meet the mandatory registration requirements
1. want continued public disclosure for new security; rr
v. Effect of registration – Once a security is registered:
1. The security may be publically traded – entire class of securities is registered; even ones that don’t trade
2. Reporting requirements –issuer now obligated to make information publically available – (timely
disclosure – if use EDGAR – instantly available to world) – required filings §13; 10K,10Q,8K
vi. Summary/example –one must become a reporting/public company to trade their securities on an exchange –
and there are three ways to become a reporting/public company – 1. voluntary register under §12a/b; 2.
Mandatory registration per §12g or 3. §15d – did a ’33 act registered offering;
1. ie if MS wants to issue class of security for just 400 people – need not register that class b/c and test for
mandatory (500 securities holders & 10MN in assets must register that class and therefore becomes
reporting company); and 12b is voluntary/optional -- AND or OR distinction?!

l. §13 – Periodical and other Reports –

i. §13(a) Reports by Issuer of security - Every issuer of a security registered pursuant to section 12 shall file
with the SEC…to ensure fair dealing in the security such information & documents…as the SEC shall require
to keep reasonably current the information & documents required to be included in or filed with an application
or registration statement filed pursuant to section 12, ….such annual reports …, and such quarterly reports…
1. Reporting companies – ie have registered class of securities under §12 must file:
a. 8-K – report events that happen with issuer
b. 10-Q – quarterly unaudited financial information (mngmt’s opinion etc)
c. 10-K – Annual report – must be filed 90 days after close of fiscal year, has detailed financial
information – disclosure is dictated by the SEC and financial statement must be audited by qualified
accountant (SEC approved) – Use GAAP;
d. SOX – §409 – duty disclose on a rapid and current basis any additional info concerning a
material change int eh financial conditions or operations of the issuer – in plain English – so no longer
waiting until the next periodic filing is due; affirmative duty to disclose;
ii. §13d – Reports by persons acquiring more than 5% of certain classes of securities – Willams Act - Any
person who, after acquiring directly or indirectly the beneficial ownership of any equity security of a class
which is registered pursuant to section 12…, is directly or indirectly the beneficial owner of more than 5 per
centum of such class shall, within ten days after such acquisition, send to the issuer of the security … to each
exchange where the security is traded, and filed with SEC”
1. If acquire >5% of class of equity stock of reporting/public company – must file FORM 13D w/in 10 days
of acquisition w/ the SEC; also notify issuer and exchange where stock traded;
a. Must disclose on Form:
i. Identity of the purchaser or group (so if few friends each own 2% if total >5% must file)
ii. Source of funds used to buy securities
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 iii. Where did you buy it
iv. Intentions – what are the purchaser’s future intentions – ie take over company etc
b. IF not reporting co. (ie not registered under §12 then no need to file frm 13D even if own >5%; so
if class of security w/ 490 holders no 12g mandatory& if not voluntary registr 12a/b then no need to file
2. MUST amend FORM 13D – for every 1% change in ownership – so can track creeping acquisitions;
iii. §13f – Reports by institutional investor – Passive investors – if institutional investor w/ no intention of
asserting control and pass 5% owernship of reporting company – then have a brief form to fill out (max 20%)

m. §14Proxy Statements and Tender Offers: - regulates the solicitation and execution of proxy statements
and tender offers;
i. Proxy: §14(a) – “It shall be unlawful for any person…in contravention of such rules and regulations as the
SEC may prescribe …to solicit …any proxy or consent or authorization in respect of any security (other than
an exempted security) registered pursuant to section 12
1. In order for anyone to solicit proxies from SHs of class of registered securities §12 (reporting
company) he must send a proxy statement (disclosure statement) giving SHs detailed disclosure about
what is to be voted on, so SHs can make an informed decision; (SEC forms for Proxy statement)
2. At SH meeting (annual/special meeting) not all SHs attend to have a proxy who follows directions given
to him by SHs via a proxy card. (ie so MS meeting proxy says I am proxy for 20MN votes – 18MN for
gates and 2MN for Joe) [Proxy is bound by law to vote way SH wants him]
a. So an individual investor receives: 3 things – proxy card to vote and sign; self addressed envelop
w/ postage to return vote and proxy statement which has info for each voting decision;
ii. Tender Offers – Williams Act - §14d,e – Tender offer – making an offer for certain % of outstanding shares
of a company from the market, ie buying large block of stock for the purposes of taking over the company,
must file FORM TO with the SEC give disclosure and must pay all SHs in Tender offer the same price and
must remain open for certain amount of time;
1. Past if wanted to buy huge chunk of company say 51% can just buy in the market quietly and
probably at different prices and as buy more shares price of shares goes up
2. Williams act – requires disclosure if want to do a tender offer – state you want to acquire x% at this price
and what your intentions are for the company; and must offer all those that tender the same price;
3. ISSUE – what is your intentions – did you try doing a creeping tender offer to avoid Williams act
disclosure – that is no good; NEED to file under Williams act before do TO, even before buy first share
4. Already disclose under FORM 13D when purchase >5% but if wanted to do a tender offer – can’t creep
around just file under Williams act before buy first share of tender offer;
5. Intentions is Q of fact – if start buying b/c not sure and file 13D and then decided that want to do Tender
offer but already own say 25% probably in trouble;

n. §15 Registration and Regulation of Brokers – Delegated to FINRA but SEC has ultimate authority
i. All brokers and dealers have to be registered/licensed with the SEC to trade/offer securities and need
sufficient capitalization; (unlawful to do so otherwise)
ii. SEC has delegated broker/dealer regulation to FINRA (NASD merged into FINRA) which is a SRO – self
regulatory organization; FINRA does the day to day regulation - such as administer licensing tests, issue
membership, approve brokers etc; So in addition to register with SEC must file with FINRA;
1. FINRA is also who public goes to if felt being cheated by their broker;
iii. Licenses actually come from SEC and SEC has ultimate authority by §15 and only delegated to FINRA;
iv. §19 – deals with regulations of SROs
v. Example – if Felon – then can’t work for broker / dealer but if want can ask for a hearing with FINRA who
then will send all transcripts and FINRA recommendation to SEC b/c SEC has ultimate authority –
o. §15(d) –filing of supplementary and periodic information - If any issuer went through a §5 ‘33act registered
offering then the issuer must continue to make periodic reports for that calendar year (of offering) and the next year
i. Even if the issuer is not a mandatory reporting company §12g and does not want to volunteer §12a/b – the
issuer must still file reports b/c if recent offering and investors want to know what is happening to their $$;
54
 ii. After the 2 years time – then SEC can determine if meets 12g – mandatory reporting or the company wants to
become voluntary reporting company- otherwise if not meet 12g and Co not want to report (ie doesn’t care if
its stock is not traded publically) – then no more continuous reporting requirements;

p. §16 Directors, Officers and Principal stockholders: regulates disclosures & txn by D,O & >10% SH of a class
i. §16(a) – Any D,O, or >10% stock holder of any class of any equity security (registered§12)– must file :
1. Form 3 w/ the SEC when become D,O or >10% SH, indicating their initial holdings (all shares owned and
price bought them at);
2. Form 4 w/in 48 hours of any transaction by the D,O or >10% SH (so all can track if CEO sells – in the
past only had to disclose annual – so could sell after 1 mos and no one knows until end of year)
a. Also use to file any change in beneficial ownership?
3. Form 5 – Annual form;
ii. §16(b) Profits from purchase and sale of security w/in six months – SHORT SWING PROFITS RULE:
1. For the purpose of preventing the unfair use of information which may have been obtained by
such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by
him from any purchase and sale, or any sale and purchase, of any equity security of such issuer (other than
an exempted security) … w/in any period of less than 6 months…shall inure to & be recoverable by the
issuer
a. If any 16a person buys/sells or sells/buys w/in 6mos the profit belongs to the issuer – if issuer not
sue any SH can sue derivatively and recover his attorney fees;
b. This has nothing to do w/ insider trading; nor does state of mind matter – purely mathematical
calculation; to make worst calculation for issuer - if 1 day after 6mos then fine;
c. Theory – mangers are to mange for the long run
d. Has to be registered stock?

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X. SECTION 10 – Manipulative and Deceptive Devices:
a. §10b It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce or of the mails, or of any facility of any national securities exchange- (b) To use or employ, in
connection with the purchase or sale of any security registered on a national securities exchange or any security not
so registered,…any manipulative or deceptive device or contrivance in contravention of such rules and regulations
as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors
i. This section includes all securities both registered and unregistered with the ’34 Act.
ii. This section is not self executing (like § 7, 9, 14, 16 etc) b/c says in “contravention of such rules and
regulations as the commission may prescribe” SO this just allows SEC to make a rule, which is rule 10b-5;

b. RULE 10b-5 – Employment of Manipulative and Deceptive Devices – [main anti-fraud rule]
i. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce, or of the mails or of any facility of any national securities exchange,
1. To employ any device, scheme, or artifice to defraud,
2. To make any untrue statemnt of a material fact or to omit to state a material fact necessry in order
to make the statements made, in the light of the circumstances under which they were made, not
misleading, or
3. To engage in any act, practice, or course of business which operates or would operate as a fraud
or deceit upon any person,
ii. in connection with the purchase or sale of any security.

iii. Analysis of Rule 10b-5

1. This is the 5th rule formulated under section 10b of the ’34 act;
2. This is basically stolen from §17 of the 33 act;
3. Review of CL fraud elements:
a. 10b-5 –Needs material misstatement/omission, scienter, reliance, causation, damages (No privity)
i. Material Misstatement/omission –is required; (reasonably foreseeable stnd to affect stk liable)
ii. Scienter – person needs to intend to fraud (make misstatement/omission); unlike §11; here
need to prove intended to do it even though knew it was false; (Recklessness may be argued)
iii. Reliance – on the misstatement/omission has to be proven
1. Fraud on Market Theory – need not prove reliance for each individual plaintiff
but just that the entire market relied on the misstatement/omission – b/c efficient markets
its all priced in; (so allows class actions)
iv. Causation – prove that misstatement caused the damages
v. Damages – are required and are unlimited; b/c its in connection with purchase or sale of any
security, any trade based on false statement is counted – so can be huge damages b/c all
traders and their damages are counted (so not based on any issuance)
1. Find reasonable way to calculate damages (many ways); D tries to mitigate
damages if loses liability by saying entire market went down the day of misstatement
50%; so only recover difference;
2. unlike §11 max damages is the offering price even if stock to zero; and §12 is
recessionary statute so again just get money paid to issuer back
vi. NO Privity – need not be proved b/c says in connection w/ purchase or sale of any security –
so need not be in privity w/ issuer – any purchases and sales are ok (like all 2˚ market trading)
b. §11 – Needs material misstatement/omission, privity and damages;

4. in connection with the purchase and sale of any security - this eliminates privity, adds
causation, and adds: If it is reasonably foreseeable that people would trade on the information then that
person liable
a. SEC v. Texas Gulf Sulphur (pg654-2d cir ’68)- TGS mining for minerals in Canada, and rumors

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 start circulating that TGS made a huge mineral find so TGS stock start rising (Friday) by Sun. 4pm TGS
execs wrote press release to make Mon papers said rumors about the significant mines were not true we
still don’t know anything for sure & are just testing; Mon morning TGS denies rumors & stock starts to
drop but PR was lie–TGS hit motherload truth came out D sued 10b5; D was found liable for MNs–Pres
is guilty but so should be GC who read it over b/c should have followed up to see if PR is true; CT if
you violate 10b-5 and you reasonably assume people will trade on it, then satisfied in connection with.
i. HOLD – “we hold that Rule 10b-5 is violated whenever assertions are made, as here, in a
manner reasonably calculated to influence the investing public, e.g. by means of financial
media, if such assertions are false and misleading or are so incomplete to mislead…”
ii. Fact that D did not sell any securities does not matter b/c liable if misstatement is in
connection with ANY purchase or sale of securities, so offending party need not trade, as
long as someone traded in connection with misstatement;
1. NO Privity Requirement like §11, or §12a so can have huge damages;
b. 10b-5 makes liable anyone who could reasonably foresee someone would trade on the info.
i. Ie. Trade journal for neurologist, article that drug works (but actually didn’t), investors read
article and traded – Ct it is reasonably foreseeable that buyers/sellers of securities would rely
on trade magazines and read them, so reasonably foreseeable that their misrepresentation
would be used in connection with someone’s purchase/sale of a security;
ii. ie. Person works at Co for research & wins noble price for own research & Co stock keeps
rising but then find out research false and stock goes down –liability need to ask if reasonable
person could foresee that her own acts which led to noble price would affect stock of Co.

5. WHO Can SUE under Rule 10b-5

a. “in connection with the purchase or sale of any security”
i. Thus it has to be someone that actually bought or actually sold a security (in reliance of the
misstatement) to sue under 10b5
1. Exception: aborted seller doctrine: someone about to buy/sell, all intentions to
do so but then deception came preventing it from happening
ii. Frustrated buyers cannot sue –ie “I would have bought but for the press release/misstatement”
iii. Frustrated Sellers cannot sue either – so if held stock from before and never sold throughout
the misstatement – can’t sue just b/c stock went down;
iv. NO privity requirement (w/ issuer)
b. Rule 10b-5 is a private right of action for anyone who purchases/sells securities in relation to info

6. Defraud: - need deception or misrepresentation by issuer;

a. Sante Fe – you need to defy, mislead, need to do something deceitful, rather than unfair
b. Central bank – must have wanted to defraud – (must be intentional – scienter)
7. Reliance –
a. Fraud on Market theory – basically relieves obligation to prove reliance or causation;
b. Basic v. Levinson -SCOTUS – embraced fraud on market theory –P still has to plead reliance
and causation but just easier to do w/ Fraud on market;
8. Causation – loss is proximate result of misstatement;
a. Dura Pharm v. Broudo – pg 713 US - Plaintiff must allege and prove more to establish a claim
under Section 10(b) claim than mere price inflation; P must also show loss causation; So makes it harder
for P to plead and prove securities fraud
9. Scienter
a. Knew statement was false or material omission –intent
i. (but also if put blinders on can satisfy intent)
ii. Hochenfelder – read into 10b5 a scienter requirement – so make it harder to sue
b. Some courts – scienter established w/ Recklessness standard
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 10. Disclosure:
a. Duty to correct – Once issuer has chosen to disclose then he has a duty to keep that info current
b. Full and fair disclosure – via ’34 act filings
c. NYSE/Nasdaq – maybe contractual obligations to disclose
d. Affirmative duty to disclose – SOX have obligation to make timely disclosures of material facts
i. SO can no longer wait until next 34 act filing to disclose
11. Damages:
a. Limited to actual damages not punitive damages but can be huge
b. Causation is a function of damages – misrep must have caused damages if not can limit damages
c. P has burden to prove act/omission of D caused loss which P wants recover; P provide amt dmgs
c. Private Securities Reform Act of 1995
i. Congress felt as though there was too much securities litigation and class actions against Corporations in 10b5
ii. This did not touch 10b-5 and its requirements but instead is just a Civil Procedure statute which makes it
harder to bring a 10b-5 action
iii. All it did was to require Pleading with Specificity for 10b-5 violations
iv. NEED to plead what statements are alleged to be misleading or what was omitted and why are they
misleading, who made them…
v. Vs past just said stock went down sue in 10b-5 and then use discovery to find out what is wrong;

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XI. INSIDER TRADING: - Trading on the basis of material “non-public information”
a. Summary:
i. Is the info Non-public
ii. Is the info Material
iii. If yes to both – What position do you have w/ the issuer? (chiarella-owe FD)
iv. How did you come upon the info?
1. Dirks – from issuer
2. O’Hagan – from your employer
3. Switzer/Electrician – accidently overheard
4. Rule 14e-3 Tender offer?
b. INTRO There is no insider trading statute; 16b is about short swing profits& has nothing to do w/ insider trading
thus SEC goes to R10b-5 but really insider trading regulation is a product of judicial interpretation of Rule 10b-5,
i. Rational for no insider trading is consumer confidence. Capital markets would come to halt if there is a loss
of consumer confidence b/c people would think the markets are rigged against you and not level playing
field / not fair so will not participate.
1. Therefore inside trading is illegal – and even though it goes on (just like crimes go on) people
invest;
ii. Phrase should be Non-public information NOT inside information;
iii. Academic Debate – insider trading is good b/c it allows information to drive the price to reflect what the true
value of the security is even if the public doesn’t know why. B/c insiders will sell to drive down price if too
high and will buy if the think more to company and price will go up;
1. But in the end – Securities laws are to instill faith in the market so can’t let people think its fixed
iv. SEC discovers inside trading – thru computers – can see average volume of stock X and see if any changes
and then see if an event occurs nearby, and if so will send questionnaire to those that traded – see if just got
lucky or were they connected - also insiders file forms with SEC on trades;

c. RULE FOR INSIDER TRADING: The mere possession of material nonpublic information in and of itself
is not a bar to trade; there most be something else, which is a breach of fiduciary duty [FD is not in statute]
i. So need more than just trade on non-public info–need somethng else like breach of fiduciary duties (ct mde up
ii. Chiarella v. US – pg 881-1980 US – D was a type-line operator at Bowne. He was typing a tender offer
document but the name of target is kept a secret, just leave out # of spaces required for target to fill in later b/c
not want the target stock to move, D figured out who the target was based on spaces left and bought the target
stock and made 30K, he was going to jail but SCOTUS let him go.
1. Analysis: Ct–D is not guilty b/c mere possession of material nonpublic info is not in and of itself
a bar to trade absent something else. Here there was no Fiduciary obligation to anyone by D. also D
wasn’t a temporary insider b/c he was the printer for the bidder and the target was blind.
a. NEED Fiduciary Duty to someone somewhere;
2. This case has been overruled twice – but the basic analysis still remains;
a. Once by O’Hagan and misappropriation theory
b. 2nd by Rule 14e-3 – No one may trade on material non-public information regarding a tender
offer. FD does not matter. (can’t trade on advance notice of TO) –
i. even if find info on subway on TO can’t trade; ???exception overheard in elevator??

d. Who may Not trade on Material Non-Public information:

i. Insiders – anyone who owes fiduciary duties may not trade on material non-public info (chiarella)
1. Who has Fiduciary duties?
a. Insiders – Directors, Officers, Employees – anyone employed by issuser has fiduciary
obligations to their employer/issuer and FD to shareholders;
b. Temporary Insiders – lawyers, accountants, consultants, tax planners, their clerical staff,
bankers Anyone that is told material nonpublic info to fulfill their duties – They hare held to have
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 Fiduciary duties/obligations like insiders.
c. Example: So if Joe finds CFO file left on subway that says unannounced earnings are low and
shorts stock – he has material non-public info and trades on it but is ok b/c owed FD to no one;
ii. On Basis of -Insiders will probably always have non-public info – so how is an insider ever to trade – if an
insider is not trading on the basis of such inside/non-public information then trading is not barred;
1. SEC v. Adler – D – pres of Co sold stock just before bad news was released and was sued by
SEC. D claimed he did not sell b/c of the bad news but for another reason so would have sold anyway; ct
agreed
a. TEST: the “but for” / “on the basis of doctrine”
i. But for the information he would not have traded
ii. He traded on the basis of such information
b. This is good law and is a question of fact for the jury but if insider shows he would have traded
anyway and the motivating factor for the trade is not the inside information then there is no liability;
i. Here the tests show that the burden is on P to show but for or on the basis (10b5(1) reverse it)
2. RULE 10b-5(1) Trading “on the basis of” material non-public information in insider trading cases
a. SEC codified Adler to define what trading on the basis of inside information is:
b. HERE burden is on Defendant – does Adler backwards b/c D presumed inside trader;
c. If you owe a fiduciary duty (chiarella) and are in possession of material non-public information,
SEC presumes you have traded “on the basis of” material non-public information and shifts burden to
Defendant to rebut the presumption thru the affirmative defenses Rule 10b5(1) provides:
d. “(c)AFFIRMATIVE DEFENSES: (1i) person's purchase or sale is not "on the basis of" material
nonpublic information if the person making the purchase or sale demonstrates that:”
i. (A) Before becoming aware of the information, the person had:
1. Entered into a binding contract to purchase or sell the security,
2. Instructed another person to purchase or sell the security for his account, or
3. Adopted a written plan for trading securities;
ii. (B) The contract, instruction, or plan described in paragraph (c)(1)(i)(A) of this Section:
1. Specified the amount, price, and date the securities to be purchased or sold;
2. Included a written formula or algorithm, or computer program, for determining
the amount of securities to be purchased or sold and the price and date for it; or
3. Did not permit the insider/person to exercise any subsequent influence over how,
when, or whether to effect purchases or sales;
iii. (C) Purchase or sale that occurred was pursuant to the contract, instruction, or plan
1. so no alterations or deviations from contract, plan, instructions
e. Most common affirmative defense by corporate execs, gates etc is RULE 10b5-1(c)(1)(i)(A)(3)
i. They adopt a written plan to sell, ie. Gates sells 100 shares MS on the first of the month,
regardless of what MS conditions are; this is how trade w/ no worries of insider trading
ii. Remember rule 144 provides volume limitations on trades by insiders even if holding
unrestricted stock

iii. NON-INSIDERS: who may not trade on material non-public information;

1. Misappropriation theory–A person commits fraud ‘in connection with’ a securities transaction
and violates 10b-5 when he misappropriates confidential information for securities trading purposes, in
breach of a duty owed to the source of the information (ie owner of info)

a. Judicial background:
i. US v. Carpenter –pg897 2d cir-1986 –This is the true misappropriation theory case but
SCOTUS denied cert; Heard on the street is a column in the WSJ which had the ability to
move the market, as market would reflect what is said when it opens. D – author of the
column told broker that he lived with what he was writing, so broker got the contents before
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 it was published and traded on the basis of that information and when article came out next
day made money. Both Author and broker went to jail. HELD – trading on information that
does not belong to you is insider trading; WSJ owned the information and the author/broker
stole information from WSJ
1. SO if WSJ traded on the information it would not have been a 10b-5 violation;
2. Misappropriation theory: Person commits fraud, violates 10b-5 when he
misappropriates info. which is in breach of the fiduciary duty owed by the person to the
owner of the info.
i. So doesn’t just have to be FD to the issuer
3. Chiarella would have been liable under the misappropriation theory
4. IF GS analysts spends time doing research& writes a report, he cannot trade on
that info. but GS can trade on that info. before it becomes public b/c they own the
information & if analysts traded he would have misappropriated info from GS and
breached his FD to GS.
ii. US v. O’Hagan -pg 889 US 1997 – this is the case that actually created the misappropiration
theory but not good case for it b/c lawyers are considered temporary insiders (since denied
carpenter SCOTUS was looking for something and took this) – D was lawyer whose firm was
brought in to work on tender offer (but D did not work on deal) and he started buying up
target stock and made money when TO announced. CT adopted the misappropriation theory
and said breached FD owed to his law firm b/c traded on material non-public information;
1. See above for rule adopted –

b. Rule 10b5(2)–Duties of trust or confidence in Misappropriation Insider trading cases

i. Applies when: “purchase or sale of securities on the basis of, or the communication of,
material nonpublic information misappropriated in breach of a duty of trust or confidence”
1. a "duty of trust or confidence" exists in the following circumstances, among
others:
a. Whenever a person agrees to maintain information in confidence;
b. Whenever the person communicating the material nonpublic info. & the person
to whom it is communicted have a history, pattern, or practice of sharing confidences
or
c. Whenever a person receives or obtains material nonpublic information from his
or her spouse, parent, child, or sibling
ii. This expands Misappropriation theory to more than just Employer-Employee;
1. Any time person agrees to keep info confident then can be liable if trade on it
2. Or if someone tells another in confidence and he trades – then liable
3. Jury question to believe you – that you told him in confidence;

2. Tippers and Tippees – as long as the tipee is not giving any benefit to the insider (tipper)
providing the information, then there is no bar to trading;
a. Dirks v. SEC -pg 900 US 1983 – Dirks, securities broker, had feeling an insurance co. was
cooking the books. He then got info from former officer/insider that books were bad, He then advised
all his clients to sell. The cooked books info finally b/m public& stock fell& SEC sued Dirks, goes up
to SCOTUS& Dirks won. Even though D got the tip from the insider, he conferred no benefit to insider.
i. Absent some benefit conferred to the insider there is no bar to trading…trading on
material non-public info is not enough:
ii. The benefit can be intangible – need not be pecuniary:
1. If give tickets to insider for info – then liable
2. If Dirks married to insider’s daughter and insider tells daughter to tell Dirks to
sell – that is also insider trading by Dirks b/c benefit to insider, daughter not suffer;
iii. IF the tipper himself doesn’t care if the tippee trades or doesn’t trade – then no liability
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 assuming tipper not trade himself;
iv. Benefit can be traced – Chain: -once the chain is tainted from the original tipper (b/c they
expected a benefit or misappropriated) it is tainted all the way down the line provided you
can prove each person knows where the info originally came from
1. Can trace benefit back – so if 10th person to trade but there is benefit to the
original tipper in some shape or form – then you can’t trade on it
v. Example: Insider tells A for benefit. A tells B without receiving benefit. B tells C for no
benefit, who trades and knows where info came from.
1. A is liable (dirks). B is NOT liable – he didn’t trade, he didn’t give any benefit to
A before he tipped, and he received no benefit as well. C is liable, but only because he
traded, and only because he knows where the info came from.
b. REGULATION FD –Rules regarding selective disclosure – (dirks was the genesis)
i. §234.100 – whenever an issuer, or any person acting on its behalf, discloses any material
non-public information regarding the issuer or its securities to any persons described in (b)(1)
of this section (securities professionals), the issuer shall make public disclosure (ma and pa
America) of that information as provided in §243.101(e):
1. Simultaneously, in case of an intentional disclosure OR
2. Promptly, in the case of a non-intentional disclosure
a. Promptly as soon as reasonably practical (but no later than 24 hrs or start of next
days trading)
ii. This was done to level the playing field b/c dirks – not liable if give info and no benefit
incurred so if give info to favorate analyst and get no benefit (no tickets etc) that is fine but
then the smaller analysts all were screwed only big analysts getting info- so REG FD
iii. Example: IF CFO has lunch w/ analysts and accidently lets slip material non-public info that
sales are down, he has to call Pres and lawyer who follow REG FD and need to promptly
disclose that non-public info to promptly – Press release
iv. Example: if it was intentional non-public info disclosure need to tell all simultaneously – ie
thru internet or conference call

3. OVERHEARING INFORMATION:
a. SEC v. Switzer – D- Dallas coach at game overhears 2 tycoons talking about a merger and D
traded on that information. Ct said simply overhearing information is not a bar to trading.
i. Analysis – D is not insider no FD, not any benefit to the tipper, and there was no
misappropriation (no connection btwn tycoons and him)
1. But if tycoons wanted to be overheard b/c wanted some trading then Dirks –
insider trading b/c benefit to Tipper so all liable
ii. Jury question – did you accidently overhear if so then no problem b/c mere possession of
nonpublic info is not a bar to trading
iii. Just like if find info on train or overhear on a plane – can trade as long as accidentally
overhear;
b. Electrician case – D is working in an office bldg and realize people talking in front of him etc.
So he puts himself in position to go to offices etc where not supposed to be doing electrician duties and
then traded on information overheard. CT – D is liable – Cannot intentionally put yourself in a position
to hear non-public information;
i. Not want to encourage this behavior so person is liable – HE would have breached a FD if he
worked for the company but he is Independent contractor so no breach in FD but still make
him liable; so not encourage people to snoop around;
c. OVERHEARING: if accidentally overhear then fine trade but if intentionally overhear
(put yourself in a position to overhear) then can’t trade – (ie can’t go breaking in places to get info
b/c you owe no FD to anyone)

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e. Damages: can be sued by SEC and any private P who qualifies under 10b5 (can recover difference in purchase
price and market price after material info is known) except that:
i. 20(A) private suits for insider trading:
1. no privity requirement liable to everyone who purchased and sold even though no idea who you
are
2. Total amount of damages shall not exceed the profits gained or lost avoided by the person/insider
ii. §21(A) – SEC can sue you for civil penalties – damages up to 3 times profit made or loss avoid– treble
damages – money paid to US treasury;

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XII. Who Can You Sue (under the ’34 Act) – Private rights of actions under the ’34 Act:
a. SEC had Identified Three Potential Defendants:
i. Primary Violators – the person with the scienter, the person that lied or committed the fraud “the bank
robber” – (must be an affirmative doer)
1. There is a private right of action against primary violator
ii. Secondary Violators – the person who helped, instrumental to the crime and intends to assist “the getaway
car driver” – but for him the crime would not have happened; (must know/intend and be an affirmative doer)
1. There is a private right of action against the secondary violator
iii. Aider and Abettors – (helps/facilitates) – Not Liable (in private action) even if integral to crime commission
“the guy that looked the other way” – sees bank being robbed but does not call 911;
1. Aiders and abettors – Does not have the scienter – does not intend for the violation/fraud (unlike
primary and secondary violators who both have the scienter and intend to defraud)
2. Aider and abettor is just in the wrong place at the wrong time
3. Aiders and Abettors are the accountants etc – their negligence in preparing financial statements facilitated
the crime, helped the fraud along – they didn’t ask the right questions – but that is not enough for liability
they did not have the scienter:
4. NO private right of action against aiders and abettors;
5. SEC can still sue aiders and abettors
6. Congress in SOX told SEC to study whether congress should pass law allowing private right of
action against aiders and abettors:
b. How to distinguish:
i. Aider and abettor do not have scienter, which primary and secondary have; (qualitative)
ii. Actor must be actively doing something positive silence and acquiescence is not enough – if not do anything
then aider and abettor not primary or secondary
iii. OR if substantial participation - less stringent then bright line test above where need actively do something to
be primary or secondary;
c. Summary:
i. Private right of action (sue and hold liable) against Primary and secondary violators
ii. SEC may bring actions and damages/fines against all three – under criminal and civil liability statutes;

d. Controlled persons of these are also liable under the ’34 act b/c not want straw violators but they do have
affirmative defenses
i. Every person who, directly or indirectly, controls any person liable under any provision of this title or rules …
also be liable jointly and severally with and to the same extent as such controlled person to any person to
whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or
indirectly induce the act or acts constituting the violation or cause of action;

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XIII. SEC ENFORCEMENT OF SECURITIES LAWS:
a. SEC may bring enforcement actions against primary violators, secondary violators and aiders& abettors

i. Enforcement: - ’33 and ’34 act are also criminal statutes but there are several steps in order to get a criminal
indictment (which can only be brought by the Justice department).
1. SEC Division of Enforcement has investigatory powers but the SEC has no criminal authority
a. For fairness purposes – SEC must show their proof to the justice dept and they will decide
whether or not to bring criminal actions:
2. SEC and FBI both are investigatory – FBI just writes a report and recommends enforcement; both
SEC and FBI can go after same person/scheme;
a. SEC has the power to call upon the FBI (if something criminal is also involved must call FBI)
b. IF civil SEC deals with everything.
3. SEC division of enforcement – since it has power to investigate has many investigators and lawyers on
staff who either investigate on their own or investigate complaints sent to them, whistle blowing etc;
a. SEC must act on all complaints received:
4. SEC Investigations:
a. Informal investigation
i. SEC just asks questions and everything is voluntary at this point, not required to submit any
information – there is no subpoena power;
ii. First thing SEC does if gets a complaint is to all the issuer/lawyer and says just got a
complaint what is going on here, you can informally talk to them and send over info / proof
voluntarily if want to
iii. Most complaints are handled this way;
iv. B/c Internal SEC rules – all complaints must be acted on even if stupid but most are handled
thru informal investigations
v. During and informal investigation – SEC does not have to tell you/lawyer whether your client
is the target for investigation - can just ask for information and you can send it if you want
1. Also does not have to tell issuer/person they are target of an investigation;
b. Formal investigation
i. IF during informal investigation the staff thinks there is something more, the staff can
petition the 5 commissioners for a formalized complaint (the commissions hold a vote to
determine)
ii. SEC now has subpoena power and therefore information submission is no longer voluntary
b/c if not comply can send subpoena and then criminal if not comply
1. Only give exactly whats asked for – no extra info or dates of data
iii. SEC now advises issuer/person that you’re the target of a formal investigation (or tells lawyer
his client is the target)
iv. Even during formal investigation the client can remain silent – ie plead the 5th – but must
give over documents subpoenaed unless again constitutional issue (5th??)
v. [can ask sec if formal or informal investigation]
c. UPON completion of formal investigation: the SEC enforcement division (staff) will make a
recommendation of whether to bring an action or not
i. The enforcement staff cannot bring any action (not even civil) so they give recommendation
to the commissioners
ii. The 5 commissioners then hold a vote to bring an action and need 3 out of 5 to vote for action
1. But SEC can’t bring criminal actions can only bring Civil actions – criminal go
to DOJ
iii. BUT in order to maintain fairness and so the commissioners do not make decision just based
on 1 side of the story – the client/person liable may make a “Wells submission” to the
commissioners to tell his side of story and try to convince commissioners not to take action
d. Wells Submission – last chance for the target before an enforcement action is possibly brought.
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 Target must give SEC enough information to convince them not to bring the action – that nothing was
wrong but Target must keep in mind that everything disclosed in a wells submission to the SEC may be
used against the target if the action proceeds:
i. SO should run the wells submission by the white collar criminal lawyers at firm just don’t’ let
SEC know this – so they don’t think your criminal;
ii. If still lose after wells submission then action will probably be brought against you;
e. MANY CASES settle at this point—SEC loves settlement; - settlement that says w/o admitting or
denying we will not do X, and SEC can turn that into an injunction so if you breach then criminal
violation;
i. Settlements can be conditioned on redoing last few years of financials b/c accounting records
not done to SEC standards etc;
5. SEC can bring action in US district court:
6. Remedies:
a. Letter of reprimand, censure, fine, cease and desist order (stop what your doing), injunction
(don’t do it again); if violate injunction then SEC will sue on injunction and can face criminal liability
b. OR ask for full sentences in law if criminal – but DOJ needs to bring

7. Civil Enforcement: - SEC can bring on its own if commissioners vote for action – and again ask
for injunctions, fines, consent orders etc;
ii. §21 – Investigations and actions:

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XIV. ETHICAL OBLIGATIONS OF SECURITIES LAWYERS (what if client from hell and not listen or if lawyer
gets too involved in the registration etc )
a. Cases: SEC brought – provide some insights on how to ethically guide lawyers: [pg 831]
i. SEC v. National Student Marketing – pg803 DDC ’78 – there was a merger by NSM which had to close by
4pm on a certain day or it wouldn’t happen. They already had a proxy vote for the merger and the vote ws to
expire so had to close that day. As the closing progressed soon learned that accountants would not give a
comfort letter and closing could not take place with out it. (comfort letter is by accountants says cold comfort
with the financials, based on review there is nothing that differentiates this quarter from previous quarters – so
not buying a falling knight). [vote by SHs etc all based on having a comfort letter at closing]. White and case
lawyer calls client at 330 or so and says no comfort letter but can give letter with language similar to just not
exact. CLIENT tells lawyer I want this deal closed, so close w/ letter as is. All happy merger went thru but
few months later NSM goes under and drags entire new company. SEC sues everyone including the
LAWYERS involved. Target lawyer settled, Acquiring lawyer said did nothing wrong followed his client – in
the end court not sanction him – old retired felt bad for him but language of case resonates:
1. “due to the obvious nature of the misleading information, especially in light of the experience of a
securities lawyer, the ethical obligations of the lawyer required the lawyer to take steps to ensure that the
information was disclosed to the shareholders”
2. “the commission’s allegations of aiding and abetting…failure of the attorney defendants to take any
action to interfere in the consummation of the merger…The court concurs with regard to the attorneys’
failure to interfere wit the closing”
3. “They knew… shareholders and the investing public were unaware of the adjustments and the
inaccuracy of the financials. Despite the obvious materiality of the information…each knew that it had not
been disclosed prior to the merger and stock sale transactions. Thus, this is not a situation where the aider
and abettor merely failed to discover the fraud”
4. lawyer trying to say not my problem that SHs proxy vote was based on having comfort letter and
argues should be management at fault only but court says NO lawyer as well
5. Securities lawyers owe a duty to both his/her client and the investing public
a. So w/in scope of ethics for lawyers you must fight vigoursly for your client and obligations just to
your client except in securities lawyers – must also consider the investing public;
b. SEC is the one that nudged this language the court adopted;
ii. In Re Carter & Johnson – had a client from hell – client wouldn’t make the proper disclosure even though
the attorney gave proper legal advice to the board, they just wouldn’t follow. SEC took action against the
lawyer; when things went wrong -(filings/prospectus wrong despite correct legal advice) ; Charlie Johnson
had all his proof that told correct advice and client not listen but SEC kept saying obligation to make the client
follow the rules. The case was dismissed on a technicality so the question still remains what a lawyer must do
1. SO SEC holds lawyers to high standards and are going after them for ethical concerns:
2. IF client not listen – go to the board and if board refuses to follow advise for proper disclosure (so
intentionally evading sec laws now) then alternative is resignation – noisy one;
iii. In Re George Kerns – there needs to be some distance btwn securities lawyer and the issuer – here issuer left
all disclosure obligations and decisions to S&C lawyer - he was also a director – but made the decisions as a
lawyer and not update when there was a material change in situation – but SEC problem with that – and also
issue – when lawyer is making materiality decisions and not giving materiality advice;

b. Statutes:
i. SOX §307–Rules of Professional Responsibility for Attorneys--Commission shall issue rules, in the public
interest& for the protection of investors, setting forth minimum standrds of professional conduct for attorneys
appearing &practicing b/f the Commission in any way in the representation of issuers, including a rule—
1. requiring an attorney to report evidence of a material violation of securities law or breach of
fiduciary duty or similar violation by the company or any agent thereof, to the chief legal counsel or the
chief executive officer of the company (or the equivalent thereof); and
2. if the counsel or officer does not appropriately respond to the evidence (adopting, as necessary,
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 appropriate remedial measures or sanctions with respect to the violation), requiring the attorney to report
the evidence to the audit committee of the BODs of the issuer or to another committee of the BODs
comprised solely of directors not employed directly or indirectly by the issuer, or to the BODs
3. [so after enron and early 2000 fallout – lots of talk about accountants and SOX but also see SOX
had impt function for lawyers – how could lawyers let this happen – So lot of NSM language made it
to SOX – only discusses public interest and investors – not client obligations; SOX 307 then gave
SEC 180 after SOX passage to act on it and so did thru Rule 205]
4. even though must disclose etc – and report – findings atty client privilege is very strong can only
breach to stop a murder or protect yourself and the only can be good lawyer is if you know everything that
happened
ii. RULE 205 –Standard of professional conduct for attorneys appearing and practicing before the
commission in the representation of an issuer: [code means securities lawyers] adopted b/c SOX §307;
Sum: Lawyer shall (must) report up and may report out [if not can get civil/criminal violations]

1. Rule 1 – Purpose and Scope: This part sets forth minimum standards of professional conduct for
attorneys appearing and practicing before the Commission in the representation of an issuer. These
standards supplement applicable standards of any jurisdiction where an attorney is admitted or practices
and are not intended to limit the ability of any jurisdiction to impose additional obligations on an attorney
not inconsistent with the application of this part. Where the standards of a state or other United States
jurisdiction where an attorney is admitted or practices conflict with this part, this part shall govern.
a. Normally local state bar sets ethical standards but here have 1st federalization of prof. ethics stnds
b. Also says if conflict these standards control:
2. Rule 2 – Definitions:
a. Appearing and practicing before the commission means representing the issuer…
3. Rule 3: Issuer as a client:
a. (a)Representing an issuer. An attorney …before the SEC in the representation of an issuer owes
his or her professional and ethical duties to the issuer as an organization. That the attorney may work
with and advise the issuer's officers, directors, or employees in the course of representing the issuer does
not make such individuals the attorney's clients
i. Therefore the corporation is who your client and who you owe duties to;
ii. Atty client privilege only applies to client the corp so if directors and officers tell you stuff it
is not covered by the privilege, they need their own attorneys;
b. (b) duty to report evidence of a material violation: - REPORTING UP - MANDATORY
i. (1) If an attorney becomes aware of evidence of a material violation by the issuer or by any
officer, director, employee, or agent of the issuer, the attorney shall report such evidence to
the issuer's chief legal officer or to both the issuer's CLO and its CEO. By communicating
such info. …an attorney does not reveal client confidences or secrets or privileged or
otherwise protected information related to the attorney's representation of an issuer.
ii. (2) The CLO shall cause such inquiry into the evidence of a material violation as he or she
reasonably believes is appropriate to determine whether the material violation described in
the report has occurred, is ongoing, or is about to occur. If the CLO determines no material
violation has occurred, is ongoing, or is about to occur, he or she shall notify the reporting
attorney and advise the reporting attorney of the basis for such determination. …Otherwise
take all reasonable steps to cause the issuer to adopt an appropriate response, and shall advise
the reporting attorney thereof. In lieu of causing an inquiry a CLO may report it to qualified
legal compliance committee
iii. (3) Unless an attorney who has made a report under (b)(1) of this section reasonably believes
that the CLO or the CEO of the issuer has provided an appropriate response within a
reasonable time, the attorney shall report the evidence of a material violation to:
1. The audit committee of the issuer's board of directors;

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 2. Another committee of the issuer's board of directors consisting solely of directors
who are not employed…by the issuer & are not, in the case of a registered investment
co., "interested persons"(if the issuer's board of directors has no audit committee); or
3. The issuer's board of directors (if the issuer's board of directors has no committee
consisting solely of directors who are not employed, directly or indirectly, by the issuer
and are not, in the case of a registered investment company, "interested persons")
iv. (4) If an attorney reasonably believes that it would be futile to report evidence of a material
violation to the issuer's CLO and CEO under paragraph (b)(1) of this section, the attorney
may report such evidence as provided under (b)(3) of this section- Directly to the audit
committee or BOD
v. [If any securities lawyer b/ms aware of evidence of material violation then he must
report up to CLO and/or CEO and then CLO must inquire and notify the securities
lawyer of his finding and basis for it if no violation – so CLO must justify to the nobody
securities lawyer or if CLO does response what it is and IF securities lawyer not belive
that is appropriate or feels it is even futile to deal with CEO/CLO – he must go to the
BOD audit committee or the independent BOD or BOD themselves]
1. reporting up: Lawyer  Chief Legal Officer and/or CEO  [audit committee of
the board  committee of outside directors  BOD;] – last 3 just depends on what
issuer has in place;
c. (d) – Issuer confidence – Reporting OUT – optional:
i. An attorney … may reveal to the SEC, without the issuer's consent, confidential information
related to the representation to the extent the attorney reasonably believes necessary:
1. To prevent the issuer from committing a material violation that is likely to cause
substantial injury to the financial interest or property of the issuer or investors;
2. To prevent the issuer, in a SEC investigation or administrative proceeding from
committing perjury; suborning perjury; or committing any act that is likely to perpetrate a
fraud upon the SEC; or
3. To rectify the consequences of a material violation by the issuer that caused, or
may cause, substantial injury to the financial interest or property of the issuer or investors
in the furtherance of which the attorney's services were used.
ii. [summary – so may report out and not violate atty client privilege issues but it is
optional so if unsatisfied with internal response that is that unless you want to report
out and also has some constitutional chilling effects – but will this apply to enforcement
actions – SEC yes, Bar – no esp if criminal]
4. RULE 4 – Responsibilities of Supervising attorneys (CLO)
a. Must comply with the reporting requirements and must make sure subordinate attorneys comply
5. Rule 5 – Responsibilities of Subordinate Attorneys:
a. A subordinate attorney shall comply with this part notwithstanding that the subordinate attorney
acted at the direction of or under the supervision of another person
b. Subordinate shall take reasonable steps if believes supervising attorney is not complying with this
section;
c. [Summary – so junior atty can’t say I was told to stop by partner, he has independent
responsibility under Rule 205, he has to go up the latter if CLO tells him to stop]
6. RULE 6 – Sanctions and Disciplines:
a. A violation of this part by any attorney … shall subject such attorney to the civil penalties and
remedies for a violation of the federal securities laws available in an action brought by the SEC
b. An attorney … who violates any provision of this part is subject to the disciplinary authority of
the SEC, regardless of whether the attorney may also be subject to discipline for the same conduct in a
jurisdiction where the attorney is admitted or practices. An administrative disciplinary proceeding
initiated by the SEC…may result in an attorney being censured, or being temporarily or permanently
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 denied the privilege of appearing or practicing before the SEC.
c. An attorney who complies in good faith with the provisions of this part shall not be subject to
discipline or otherwise liable under inconsistent standards imposed by any state or other US jurisdiction
where the attorney is admitted or practices.
d. [Summary – so can have civil and criminal liabilities and may be barred to practice before
SEC but if comply with rule in good faith and it is inconsistent w/ state laws etc – you are not
liable]
iii. THIS came out after enron scandals etc – which happened b/c all losses were being put in offshore
corps that the lawyers kept making; Many offshore subsidiaries for enron – issue if client asked lawyer
to set up offshore sub would it have been lawyers obligaton to ask why, or should he say no more if
made lots of them, 205 makes it so junior associate making these subs may have to go to the partner and
now partner has to find out and report back;

c. SPEECH by Harvey Goldschmidt – RULE 205 already foreshadows reporting out but its not required – Harvey
would have probably made reporting out mandatory instead of optional.
i. Harvey – is previous SEC commissioner and now back to teaching
ii. Lawyers role in corporate governance:
1. “What is the lawyers role when acting as a responsible professional and public citizen today?”
2. “There is, I believe a broad consensus that lawyers should play a critical gatekeeping role in large
public corporations. The term “gatekeeper” suggests a guardian with independent professional
responsibilities, including a responsibility for protecting the institution. Certainly, this was virtually
unanimous view of Congress when, in Section 307 of Sarbanes Oxley, it required the SEC to establish a
system for lawyers to report wrongdoing up the corporate chain of command or ladder and to establish
other “minimum standards of professional conduct.””
iii. SO says lawyers are gatekeepers protect the corporation and responsibility element; and must enforce the
securities laws;
iv. Lawyers must not assist or participate in client committing fraud
v. HE says reporting out – is something bar is not against b/c break privilege if bodily harm or to protect yourself
and therefore now more important to protect investing public then to have confidentiality
1. There is conflict btwn obligation to public and obligation to the client b/c client should be able to tell
lawyer anything and now if make them tell SEC there is issue
2. This is open debate right now;
3. Noisy withdrawal – stop being attorney b/c client does bad stuff and won’t listen but make noisy
withdrawal to alert others? Like put in WSJ;

d. SUMMARY OF ETHICAL OBLIGATIONS OF SECURITIES LAWYERS:

i. Started with NSM – owe obligation to client and investing public
ii. THEN SOX said rules for public interest and to protect investors
iii. THEN RULE 205 – mandatory reporting up by lawyers - disclosure of any violations
iv. Reporting out – is permissive right now but in future – Harvey Goldschmidt says we are headed to
make it mandatory, that’s what he wants

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XV. Sarbanes Oxley (SOX) – [post enron, worldcomm, tyco, Adelphi etc]
a. Need investor confidence in capitalist system w/o it no capital comes in and system collapses – 33 and 34 act
were aimed to provide investor confidence; and securities laws always reactive to problems;
b. Purpose:
i. SOX is not an act – instead it is amendments to the existing securities laws;
ii. Every SOX was provisions in response to some perceived wrong doings or defects in the system – in order to
encourage consumer confidence after this bad era – by showing them that these things are illegal;
iii. One major area needed to be addressed was the accounting profession – if the public cannot rely on
independent public accountant audits, which are the lifeblood of disclosure then confidence falters;
1. How can a major accounting firm get it wrong and say a company is worth billions in net worth but
actually is broke – thus confidence in reporting companies finance statements are gone;
c. Creates Accounting oversight:
i. First thing congress did was to establish the Public Company Accounting Oversight Board
1. This is an attempt to increase consumer confidence – PCAOB is an independent committee subject to
SEC oversight
2. PCAOB – requires registration of an accounting firms that audits public companies b/c the power
to require registration is the power to regulate. (b/c once registered firms have to follow PCAOB’s rules)
a. PCAOB regulates auditors;
b. PCAOB also regulates the ethics of accountants;
3. PCAOB sets standards that the accounting firms must follow, SOX gave them power to set standards for
the entire accounting industry –
ii. SOX makes it unlawful for an registered public accounting firm conducting an audit of a public company to
contemporaneously do any non-audit services - (AUDITOR INDEPENDENCE)
1. Public confidence is based on the independence of auditors – auditor has public responsibility
2. Past auditing service was very low dollar amount compared to the consulting services the accounting firm
would provide the client – like tax advice, due diligence on acquisitions etc; Therefore if there was an
irregularity in an audit, the Company would say we only hire team players, if you can’t quiet that auditing
issue we won’t give you any of our other business (which is much more profitable for the accounting firm
then the auditing business) also these accounting firm partners were given lots of perks from public
companies (enron etc)
iii. Additionally Public companies must have an independent audit committee (usually independent directors) and
at least one member of the audit committee needs to be financially sophisticated
1. They must keep records of all complaints related to auditing matters
2. Must pre-approve any non-audit services
3. The annual accounting fee must go thru the audit committee –(so management can’t buy out an
accounting firm etc for faulty audits)
4. Only the audit committee can hire and fire accountants
5. The accounting firm must give the audit committee all correspondences btwn the auditors & management
iv. Every 5 years the auditors must send a new audit partner to the public company – prevents any auditor from
getting to cozy
v. Also there is 1 year cooling off period for any accountant who worked on a client audit and now wants to
work for the client; so an entire cycle will pass just in case the auditor was actually bribed – there is time to
see any faults in the audit;
vi. SOX also makes management personally liable for the financials reported –
1. Management was already liable or faulty disclosure thru the 33 and 34 act but SOX has a certificate for
management to sign which holds them out even more – certify financials are correct and have internal
controls allowing for escalation if there are any problems;

d. RELEVANT PROVISIONS OF SOX:

i. § 101 – Established a Public Oversight Accounting Board – oversees the audit of public companies.
Unless an accounting firm is registered with this board it may not audit a public company.
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 ii. § 201 – Auditor independence: It shall be unlawful for a registered public accounting firm to provide the
audit services with any non-audit services. Auditors should be at arms length of the client
1. §204-the auditors must report to the audit committee – critical accounting policies, alternative treatments
and material written communications w/ management;
iii. §301 – Every publicly traded company must have an audit committee
a. Every public company must have an audit committee that is made up of at least 2 or 3 outside
(non-management) directors.
b. AT least one must be sophisticated and knowledgeable in financial or accounting matters
iv. §302 – Every ’34 Act filing must be certified personally be the CEO that he/she finds noting material or
misleading in it. (have always signed the registration statement under the ’33 Act). Certifying that there are
no 10n-5 violations.
1. You have to certify:
i. They have reviewed the report.
ii. Based on their knowledge it does not contain or omit a material misleading fact.
iii. Presents fairly the financial condition of the company.
iv. Responsible for implementing internal control to create procedure to filter the information up
to the signing officers. (that you have designed transparent internal controls)
v. So avoid Enron problems
vi. §404 reqs each annual report under the '34 act to contain an internal control report which
shall state the responsibility of management for establishing and maintaining an adequate and
internal control structure and procedures for financial recording containing an assessment as
of the end of the most recent fiscal year as to the effectiveness of those internal controls.
2. If you sign the report and you lied, you can go to jail, $5M fine or 20 years in jail.
v. § 303 –improper influence on conduct of audits: it shall be unlawful for any officer or director of any issuer
or any other person acting under the direction thereof to take any action to influence, coerce, manipulate,
mislead any independent or CPA engaged in the performance of an audit
1. Even if try then in violation
vi. §304 – forfeiture of certain bonuses and profits - any bonus paid on the basis of financial statements found
to be fraudulent must be repaid.
1. Past management would overstate earnings etc b/c gets performance based comp, but now if financials
discovered to be wrong – disgorgement – have to pay back the bonuses;
vii. §306 – Insider Trading during pension fund black out periods – Prior to announcement of the earnings,
employee pension or benefit plans cannot trade b/c 10 days before the earnings come out people know what
earnings are going to be like. Likewise senior management can’t trade during the period.
viii. §307 – Rules of professional responsibility for attorneys – see above
ix. §401 – Disclosures in periodic reports – (j) – off balance sheet transactions – all annual and quarterly
financial reports filled with the SEC shall disclose all material off-balance sheet transactions, arrangments,…
x. §402 – Enhanced conflict of interest provisions: It is unlawful for any public company to lend money to
officers or directors. [some exceptions]
1. IN the past, major corporations would issue loans to D&O that were not reported as compensation
because they were a loan, and then later forgive the loans or used loans to buy up stock and then price goes
up sell the stock keep proceeds and pay back loans
xi. § 403 – Disclosure of Txn involving management and principal stock holders: officers/directors have to
report their trades in the issuer’s securities to the SEC. must be reported within 48 hours so that it will be
viewable on the SEC website within 72 hours.
xii. §404 – Management assessment of internal controls: demonstrates the breadth of SOX - SEC shall
prescribe rules and regulations requiring each annual report under the ’34 Act to contain an internal control
report which shall state the responsibility of the mgmt for establishing and maintaining an adequate internal
control structure and procedures for financial reporting and contain an assessment as of the end of the most
recent fiscal year of the effectiveness of those controls
1. every public company must now hire outsiders to assess the controls
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 2. every public company must adopt a code of ethics and adhere to them
xiii. §406 – Code of Ethics for Senior Financial Officers: requires every public company to have a management
code of ethics and establishes standards to promote the honest and ethical conduct for the handling of actual or
apparent conflicts of interest.
xiv. § 407- Disclosure of Audi Committee Financial Expert - the SEC can issue rules
xv. §408 – enhanced review of periodic disclosures. Congress wanted the SEC to do more review. Will
consider past material misstatements.
xvi. §409 – Real Time Issuer Disclosures - Each issuer reporting under §13 or §15 shall disclose to the public on
a rapid and current basis (now there is a duty to disclose to the public in a rapid and timely manner) such
additional information concerning material changes in the financial condition or operations of the issuer in
plain English as necessary or useful for the public interest or protection of investors
1. Must be in plain English.
2. S-O affirmative duty to disclose any material change
3. Reg FD gets rid of good old boy network too.
xvii. §501 - Conflict of interest for Security analysts recommend equity securities– there must now be a wall
between the analysts and i-bankers. In the past, analysts bonuses would be pegged to the results of bankers
performance. Created an incentive for the analysts to lie in financial prospectuses of certain stocks to help
generate revenue for the company Don’t want to create a conflict of interest between the two groups
1. the SEC has to establish rules to protect the objectivity and independence of securities analysts by:
i. restricting the prepublication clearance or approval or research reports by persons employed
by the broker who are engaged in investment banking activities
ii. limiting the supervision and compensatory evaluation of securities analysts to officials
employed by the broker or dealer who are not engaged in investment banking activities; and
iii. requiring that the broker who is involved in the investment banking of a firm may not
retaliate against or threaten against any securities analysts as a result of an unfavorable
research report that may adversely affect the investment banking relation
xviii. §905- Amendment to sentencing guidelines related to certain white collar offenses – allow sentencing
commission to review and update sentences to reflect the serious nature of the offenses.
1. Now up to 10 years in prison and 1MN fine and if willfully up to 20 years in prison past used to just be 3-
5 years;

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XVI. Investment Company Act of 1940 (aka ’40 Act)
a. Past discussions with Howey – can take barrels of scotch sell interst in them and create a security
b. Instead put stock & securities in a pool & sell interest in them – that is a mutual fund; - this was in past separate
stocks with ownership in the separate stocks, but now w/ pooling treat the entire pool as a different security
i. Its just a securitization of securites
c. Problems leading to crash and in 30s are these investment Pools where people would pool their money and buy
securities as a group: - 2 main problems with this:
i. Investment companies (pools) fleeced investors – they had poor disclosures, money disappearing, shady
characters running it – saying they were investing in blue chip and instead putting money in foregn country
commodities etc; so they were engaging in every risky behavior (but that is not want investors signed up for)
1. And riskyness is allowed but only if have proper disclosure so investors know your investing risky
ii. Investment companies (pools) can effect the market – they have lot of money and securities in their ownership
so they can affect the market and in past they were extremely leveraged so more effect on the market and if
there were margin calls – by dumping these huge stocks can really move markets and cause spirals of margin
calls – (these companies wielded more money then the richest people in the world
d. Since investment pools got such a bad rep –they changed their name to mutual funds
e. PURPOSE:
i. The 40 act largely regulates mutual funds – even though the phrase is never mentioned in the act and
instead they are referred to as investment companies [these funds are also subject to 33 act registration]
ii. The act serves to regulate investment companies to protect investors(so don’t get screwed by people running
the fund) but also to protect the capital markets – especially given the amount of $$ these companies wield;

f.PROVISIONS of the Investment Company Act of 1940

i. §1 Findings and Declaration of Policy: upon the basis of facts disclosed by the SEC…. it is hereby found
that investment companies are affected with a national public interest”
1. since affects national public interest they can be regulated;
2. So a private company that raises money to buy securities instead of making widgets is matter of public
interest and therefore no longer free to do what it wants (it was challenged in court and act upheld)
ii. §2 – Definitions - generally more impt is §3
iii. §3 – Definition of an Investment Company: This is the critical inquiry b/c if you fall under this definition
and are an investment company then the entire act applies to you; (and must register as IC) lots regs
1. Two Tests to determine if IC:
a. Subjective test: §3a1A - "investment company" means any issuer which is or holds itself out as
being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or
trading in securities;
b. Objective test: §3a1C - "investment company" means any issuer which is engaged or proposes
to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns
or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such
issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis
2. NOTES – subjective is hold your self out but in object not matter if don’t’ hold yourself out as
long as doing it and >40% of your total assets is securities:
a. Why have the 1st test if have 2nd since most people don’t want extra regulation anyway:
i. Example – Mutual fund just opened gets 2MN capital and since mutual fund hold themselves
out as primarily in the business of investing in securities but if they take say 1.8MN to buy a
bldg and computers etc and only invest 200K in secuirites – they do nto meet the objective
test – 40% of total assets is not securities, yet they are an investment company b/c hold
themselves out as one; - subjective test;
b. This can trap unwary issuers – if Co had extra money and investing is not their business but they
do some of it and >40% assets in securities then you’re an investment company and must register but
have some exceptions:

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3. §3b – Exemptions from Provisions: Notwithstanding §3a1C (>40% assets is securities) none of
the following persons is an investment company:
a. (1)Any issuer primarily engaged, directly or thru a wholly-owned subsidiary or subsidiaries, in a
business or businesses other than that of investing, reinvesting, owning, holding or trading in security
i. This is the Operating company Exception (operative provision overlay)
ii. Must show in good faith that you really are an operating company b/c sometimes you can
pass the threshold – say raising capital to build new factory – if have lots of cash invest in
securities while waiting to build and may pass the threshold but can still avoid IC; (but can’t
just have all that securities and buy 1 hot dog stand and say really are an operating company)
iii. “through a wholly-owned subsidiary” – so if you’re a holding company like Citigroup –
100% of its assets are securities (100% stock in Citibank, 100% stock in travelers etc)–so
§3a1C - >40% total assets is securities and engaged in holding securities – HOWEVER,
Citigroup is not an investment company despite the fact it passes the test b/c if thru subsidiary
engaged in business other than holding trading securities – then still have the operating
company exception:
1. Citigroup’s subsidiaries are engaged in business other than investing and so the
holding company Citigroup thru its subsidiaries is not an investment Co.
b. (2)Any issuer which the Commission, upon application by such issuer, finds and by order
declares to be primarily engaged in a business or businesses other than that of investing, reinvesting,
owning, holding, or trading in securities either directly or (A) through majority-owned subsidiaries or
(B) through controlled companies conducting similar types of businesses. [also see §6 below]
i. Congress gave SEC plenary (complete) authority over the investment company act – so can
plead to the SEC that even though you meet the test your not an investment company; and the
SEC can exclude you.
ii. Since lots of regs – congress gave SEC power to exclude at risk of overregulation;

4. §3(c)-Further Exemptions- (10)(A) Any company organized and operated exclusively for
religious, educational, benevolent, fraternal, charitable, or reformatory purposes--
a. no part of the net earnings of which inures to the benefit of any private SH or individual; or
b. which is or maintains a fund described in §3(c)(10)(B).

5. HEDGE FUNDS – HUGE EXCEPTION TO INVESTMENT COMPANIES:

a. Investment club – group of people would pool their money and invest together. Congress said
they didn’t want to regulate groups of old ladies getting together and investing their money (ie
bearstown ladies); these clubs are basically partnerships – not need a written agreement to form and they
hold themselves as primarily investing in securities and 100% of their assets are securities but they are
not investment companies b/c:
b. §3(c)(1) – Notwithstanding §3(a) none of the following persons is an investment company-
Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not
more than one hundred persons and which is not making and does not presently propose to make a
public offering of its securities.
i. SO if <100 investors and not making a public offering then the 40 act does not apply
ii. Background: - after the war, late 40s lots of people coming back and started investing
money, they didn’t know brokers or do their own trades so they invested in mutual funds and
mutual funds industry exploded: - Some people read the act and then used §3c1 – to create
hedge funds – by having 100 investors but having high investment requirements – like 10MN
per person – can have a 10BN hedge fund w/ the 100 investors ---SO all hedges are is a
totally unregulated mutual fund (investment company) b/c they kept the # of investors @100;
Next dilemma for hedge funds is getting money/capital by definition they can’t do a public
offering and So they raise money thru RULE 506 offering, the non-public offering safe
harbor – sell to accredited and max 35 sophisticated investors. RULE 506 has no dollar limit
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 so can raise as much as they want [vs Reg A or 505–5MN cap]
c. HEDGE FUND description: an unregulated investment company (mutual fund), which raises
money thru a 506 offering and can have up to 499 investors if all QPs otherwise just 100 investors and
its statutory basis is §3c1,7; and it can’t do public offerings in either statute to be exempt – so use 506
d. Hedge funds – Why so lucrative:
i. Hedge funds are 2 components the hedge fund itself–which holds the money/securities and a
hedge fund operator (an LLC which is a management co.) which has contract with the hedge
fund, which allows for 2% of the base as management fee & 20% of the profit; (2/20 split)
1. So if it is a 1BN dollar hedge fund – the fund operator gets 20MN base and if the
fund made 10% profit (which is nothing extraordinary) 100MN –gets 20% = so another
20MN – So gets 40MN in 1 year;
2. HEDGE fund operators – get all the rewards and zero risks – b/c regardless of
what happens get 2% of the base and if take crazy risk and it works get 20% of the
upside; - So incentive is to take risks;
ii. Investment Companies – fees to management are regulated and cannot be performance
based; - so takes less risks (comp around 1% of overall portfolio)
iii. SEC is trying to adopt regulations for hedge funds – under advisors act?
e. Hedge funds – Number of investors:
i. 100 investors max b/c of §3(c)(1)
1. This is why only allow rich investors so can max out your Fund; and 506 says
any wealthy person is accredited investor and can have unlimited accredited investors in
506;
a. But can also do 35 purchasers as long as sophisticated and need not be wealthy –
but hedge not want to waste spot on person that is not wealthy – which is why people
say hedge fund for the rich;
2. If an entity is formed for the purpose of investing in the fund – then look through
and count each investor in the entity as a separate investor in the fund;
3. If entity formed while back – say family company – then can invest in fund and
only count as 1 investor – no look thru
a. Caveat – if any entity owns more than 10% of the 3c1 then look thru unless it is
an operating company – so if MS owns 40% of 3c1 – no look thru (exception to the
exception) and only counts as 1 investor;
4. A 3(c)(1) fund can own another 3(c)(1) fund as long as own <10% of that fund,
then only count as 1 person (beneficial owner count as 1 person) but if own >10% of the
fund then must look through and count each individual so ruins it;
ii. §3(c)(7) – If an issuer (fund) the outstanding securities of which are owned exclusively by
Qualified purchasers and you do not make a public offering – then there is no limit for
qualified purchasers:
1. Qualified Purchasers: - natural person with $5MN in investments or person who
controls $25MN in investments (institutions)
2. Practically speaking all hedge funds limit themselves to 499 investors b/c if have
500 SHs and 10MN in assets then must register under §12g of the ’34 act – as a
Reporting company and therefore are subject to regulations and disclosures and last thing
hedge fund wants to do is disclose info)
3. This was passed in 96/97 b/c hedge funds complained about the 100 investor
limit
iii. SUMMARY: - totally unregulated and can have up to 100 investors or have up to 499
qualified purchasers – but entire fund needs to be exclusively QPs and reason <500 is so not
have disclosure and become reporting company under §12g
f. MULTIPLE Hedge Funds: Can a hedge fund operator (management company) bypass the
number of investor requirement by opening and managing many funds each with 100 investors?
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 i. Answer is it depends:
ii. Integration Test: would a reasonable investor view the separate funds as different
investments;
1. IF funds look similar then integrate and so exemption is ruined b/c >100
investors
2. If funds have different investment strategies – ie biotech fund, energy fund – then
that is fine – no integration and so 1 hedge fund management company can run them all;
iii. BY statute – Congress allows hedge fund operator to manage identical §3(c)(1) and §3(c)(7)
funds without integration
1. But if multiple §3(c)(1) funds that are same then they are integrated
2. IF multiple §3(c)(7) funds that are the same then they are integrated;
g. Benefits to not being registered under the 40 act: - not need to act for long term capital
management and therefore can do short selling and buy on margin which investment companies cannot;

6. TWO Co. that fit the definition of an investment company and are subject to the regulation
of 40act
a. Unit Investment Trust (UIT) – [generally is trust but does not need to be can be corp]
i. Static portfolio – a promoter buys X MN units of stocks/bonds/securities and once completes
the portfolio will not change (the pool of investments and the % of each security in the pool
will not change). The securities are put into the pool and the management company sells
interest in the trust/fund/pool (ie so each investor owns say 1/1000th of the trust if sells to
1000 investors). Since the fund is created and does not change each investor knows exactly
what securities are in the fund from the disclosures since this is a 33 act – selling security –
have registration/disclosure statement.
1. Market for UIT – is huge market, primarily retired people b/c know exactly
what they are buying. And often the trust/pool is made up of not common stock but
instead bonds (govt, muni, class A debt securities), all which pay interest. The bonds etc
are staggered in the trust so that the retiree can get monthly checks of dividends/interest
corresponding to their share in the trust (management company does take its fee).
ii. Redeemable Security – Each undivided beneficial interest in the trust/pool/fund must be
redeemable. It is redeemable every single day at the NAV price at 4pm.
1. Net Asset Value (NAV) – is the price for redemption – all UITs are valued once
a day at 4pm the close of the market, by the promoter (does so by pulling the price of
each of the units in the UIT a the close of the market)
2. Forward Pricing – If call for redemption, the person gets the forward price
(NAV) – the future 4pm price is the selling price. So if call at 3pm get the 4pm price
when interest is sold, if call at 401PM Monday get the Tuesday 4pm price. This is
intended to prevent playing with the NAV, since all interest are redeemed at the NAV.
3. Portfolio is static but if people require redemption how does the
promoter/management get funds to provide the investor?
a. Promoter is allowed to sell units in the static fund on a pro rata basis to create
cash for to pay out the redemption. (sell correct % of each so composition still same)
b. So no after market trading just NAV following day;
4. If investor calls often have a check w/in 3 days;
5. UITs have a finite limit – so all terminate
6. If TOO much redemption can have lots of selling and depression in market

b. Management Investment Company – has a dynamic portfolio – so constant buying and selling
– and running money – The disclosure just provide type of fund – ie growth, value, risk, biotech; [often
run by corp but can be LLC or partnership]. There are 2 types both dynamic port. but diff redemption

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 i. Open End Management Company: Issues redeemable securities
1. Similar to UIT in terms of redemption;[usually get check w/in 3 days]
2. Must offer investors ability to get money back – redeemable securities
3. Redemption is based NAV at 4pm has Forward pricing;
4. Liquidity is of concern – b/c money is needed for redemption requests –
management company must be sure to have liquid assets in the fund b/c mngmt co needs
to sell the securities in the fund to get money/cash for redemption–
5. if the economy is going down there are a lot of redemption requests and the fund
must sell the stocks to get cash for redemption (even if stock is a great deal) and therefore
the fund managers can move the market – esp if too much selling. – so like snowball
effect b/c sell and market drops and then more selling b/c more redemption requests.
6. Vast majority of mutual funds are open end management companies;
ii. Closed End Management Company: issues non-redeemable securities;
1. Since securities are non-redeemable – liquidity is not as much a concern so can
invest in thinly traded companies, smaller companies, can invest more long term illiquid
situations
2. Secondary Market for Trading – since an investor cannot get his money back
from the fund – in order to get money back there is market for these securities just like
stocks. At the close of trading – the close end management company pulls the NAV of
the fund and the papers will report bid/ask and NAV of each of the funds. This is after
market trading b/c need the NAV to be pulled and money is received by the investor
selling his fund position (unlike open ended where fund manger actually redeems the
investor)
a. SO no redemption just After market trading
b. Open ended not have secondary market b/c any investor can redeem at will and
get the NAV so no need, the fund has liquid assets for redemption at will; and
always willing /required to redeem so not need to sell and find buyers and NAV is
the market price, no need to sell for less and buy for more, b/c fund will give you
NAV.
7. Example: Fidelity – a public company – sets up many investment companies – UITs, open and
close ended funds etc – and then takes a management fee from each of these funds- there is no real manger
at the fund/investment co.–fidelity is the management co. for all them; and the fidelity staff runs all of
them
8. IF investment company – then must register under 40 act – see below; and register under ’33 act
section 5 to raise capital from public (register the offering) and register the class of securities under the ’34
act;

Back to provisions:
iv. §6(c) – Exemption of persons, securities or any class or classes of persons as necessary and appropriate
in public interest. The Commission, by rules and regulations upon its own motion, or by order upon
application, may conditionally or unconditionally exempt any person, security, or transaction, or any class or
classes of persons, securities, or transactions, from any provision or provisions of this title or of any rule or
regulation thereunder, if and to the extent that such exemption is necessary or appropriate in the public interest
and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of
this title
1. Congress gave SEC a safety valve – very broad exemptive authority – SEC even on own motion
can exempt anyone from the act – which is big deal;

v. §7 – transactions by unregistered investment companies: (a) No investment company organized or

otherwise created under the laws of the US or of a State and having a board of directors, unless registered
under section 8 shall directly or indirectly…offer/sell securities, engage in any business etc
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 1. IF deemed an investment company, then can’t do business unless register the company with the SEC.

vi. §8 Registration of an Investment Company: - tells you how to register – long painful process 3-6mos;
1. Can only register if have at least 100,000 in capital
2. IF investment company – then must register under 40 act – see below; and register under ’33 act
section 5 to raise capital from public (register the offering) and register the class of securities under the ’34
act;
3. Power to register is power to regulate

vii. §9 – ineligibility of certain affiliated persons and underwriters:

1. It shall be unlawful for any of the following persons to serve or act in the capacity… of any
registered investment company, or principal underwriter for any registered open-end company, registered
unit investment trust, or registered face-amount certificate company
a. any person who within 10 years has been convicted of any felony or misdemeanor involving the
purchase or sale of any security or conduct as a securities person.
b. any person who, by reason of any misconduct, is permanently or temporarily enjoined by order,
judgment, or decree of any court of competent jurisdiction from acting as …securities person;

viii. RESTRICTIONS if INVESTMENT COMPANY:

1. Illegal to purchase securities on margin (so can’t use leverage like hedge funds)
2. Illegal to sell short
a. Long – hold asset/stock – profit if go up
b. Short – sell borrowed shares – profit if go down- b/c if stock goes up need to cover that and to
get cash need to sell other stocks under management;
3. Illegal to have fund of funds–b/c advisors fee would accumulate–(certain exception–3% in
another fund)
a. Charge fund fee to run fund and then take all money of that fund invests in fund b, which also has
a fund fee and keep doing it – then takes away all money from investors just becomes all fees;
b. SO no RIC investing in another RIC (outside of exception)
4. Illegal for investment company to make personal loans – to like management etc
5. Can’t take on more debt than 300% of assets;
6. No performance based bonuses and limits compensation from funds to advisors to say (1%)
7. Can only K with registered investment advisors
a. Each investment company has a K w/ an investment advisor – the management company that
charges a fee to manage the fund (ie fidelity growth mutual fund is managed by investment advisor
fidelity; - get like 1% of base compensation )
b. K can’t be more than 2 years in length – in writing, not assignable, must be approved by
independent directors.
8. Need a different (unaffiliated) broker then the fund company /operator – so no churning
a. Not want the fund, who is buying selling to get the commission b/c then would do unnecessary
trades, so broker cannot be affiliated w/ the investment company.
9. Need to have a different(unaffiliated) underwriter then fund company/operator b/c can’t pay yourself
10. NO real regulations on investment but must stay w/in the parameters of your strategy and can’t
change investment policy w/o a majority vote of investors;
a. IF want to be called a diversified investment company have SEC required parameters of
diversification:
i. 75% of assets are invested in security but
ii. no more than 5% of assets in any one company
iii. do not hold 10% of voting power of one company
b. If meet these – marketing advantage call your self a diversified investment;
11. INVESTMENT Company BOD
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a. BOD must be composed of at least 60% of directors unaffiliated with the advisors (management
company/advisors – so unaffiliated to fidelity)
i. Exception: [open ended] No load fund (no sales load)
1. Sales load is a sales commission to join the fund – class is 2% fee of investment
2. IF there is no sales load rationale to not require unaffiliated board is that
investors can easily enter the fund and leave the fund if not like what getting b/c they
didn’t ay a fee that makes them hang on longer;

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XVII. Investment Advisors Act of 1940 – aka Advisors Act:
a. Provisions:
i. §201 – Findings: Upon the basis of facts disclosed by the record and report of the SEC … and facts otherwise
disclosed and ascertained, it is hereby found that investment advisers are of national concern.
1. As before – investment advisors are a national concern so that means they can be regulated

ii. §202- Definitions:

1. (a)(11) - Investment adviser means any person who, for compensation, engages in the business
of advising others, either directly or through publications or writings, as to the value of securities or as to
the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a
regular business, issues or promulgates analyses or reports concerning securities; but does not include:
a. bank or bank holding company [even though banks advise securities better regulatory authority]
b. any lawyer, accountant, engineer, or teacher whose performance of such services is solely
incidental to the practice of his profession [advice is incidental to main duties]
c. any broker or dealer whose performance of such services is solely incidental to the conduct of his
business as a broker or dealer and who receives no special compensation therefor;
i. giving advise is only incidental to main job as broker and gets no comp for advise
d. the publisher of any bona fide newspaper, news magazine or business or financial publication of
general and regular circulation;
i. Lots of wise guys try to give investment advise and say only selling newsletter – turns on
facts is it general circulation;
e. any person whose advice, analyses, or reports relate to no securities other than securities which
are direct obligations of or obligations guaranteed as to principal or interest by the US, or securities
issued or guaranteed by corporations in which the US has a direct or indirect interest which shall have
been designated by as exempted securities under §3(a)(12 of ’34 act
i. Advises on purchase of govt bonds:
f. any nationally recognized statistical rating organization, defined in section 3(a)(62) of the ’34 act
unless recommends securities;
g. such other persons not within the intent of this paragraph, as the Commission may designate by
rules and regulations or order
i. So anyone else SEC wants to exempt;
2. Summary – have broad definition – advises for compensation – then lots of exceptions; -
compensation is problem b/c there is an inherent conflict and also self dealing issues;

iii. §203 – Registration of investment advisors –(a) it shall be unlawful for any investment adviser, unless
registered under this section, to make use of the mails or any means or instrumentality of interstate commerce
in connection with his or its business as an investment adviser
1. Can’t be in business unless register with the SEC
2. Registration is simple (unlike RIC) – fill out FORM ADV – file with the SEC who acts w/in 45 days
a. FORM ADV – 2 parts –Part 1 asks a number of questions about you, your business practices, the
persons who own and control you, and the persons who provide investment advice on your behalf.; Part
II is your current brochure. You must continue to amend your brochure, deliver it to prospective clients,
and annually offer it to current clients
b. Basically your background and philosophies; any felonies – though probably can’t even register
3. State vs. Federal registration:
a. Past had to register both SEC under advisors act and state
b. If you advise 25MN or more (or advise a registered investment company) then must register with
the SEC only under the advisors act and not home state federal preemption
c. IF advise less than 25MN register under the state govt and not under Advisors act;
d. SEC no exam (just forms) some states have exams;
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 4. Registration needs to be updated yearly – annually amend brochure etc?
5. §203(b) Investment advisors who need not be registered (Exemptions)
a. any investment advisor, all of whose clients are residents of same state as his business and he
does not furnish advice with respect to securities on any national securities exchange.
b. any investment adviser whose only clients are insurance companies;
c. any investment adviser who during the course of the preceding twelve months has had fewer than
fifteen clients and who neither holds himself out generally to the public as an investment adviser nor
acts as an investment adviser to any investment company registered under title I of this Act
i. This is the hedge fund exception: - each hedge fund that a hedge fund operator /
management company advises/manages is only 1 client; so
1. if less than 15 clients
2. Not hold self out as investment advisor
3. Not advise a registered investment company
ii. then exempt from registration under advisors act
1. if had to register as an advisor there would be no performance fees;
iii. Few years ago – SEC changed regulations and said each fund is not just 1 client but instead
look thru the hedge fund and all investors in the fund are clients of the hedge fund operator –
so no longer qualify for exemption from the advisors act.
1. There are 2 exceptions: where hedge funds can still take performance fee:
a. Grandfathered if trading before 2006 – all clients etc
b. For new clients if performance comp – need clients to be Qualified investors –
invests 750K or has net worth over 1.5MN [so even registered advisors can do this]
2. GOLDSTEIN Case – sued SEC – SEC lost – not have power to do make the
change – and so allowed all hedge fund mangers to withdraw registration - but ½ did not
b/c it is marketing tool; pensions etc liked that registered investment advisor and
suggested to keep it and they can still get 2/20 b/c grandfathered from past or only take
on QIs as clients;
d. any investment adviser that is a charitable organization
e. any investment advisor registered with the commodities future trading commission

iv. §205 Investment Advisors Contracts

1. (a) compensation – no investment advisor may receive compensation based on capital gains
a. NO performance based compensation – its illegal – b/c not want risky speculative investments
b. BUT what about hedge funds – SEE above they are exempt from registration as investment
advisor – so even thought the fund operator gives advice for compensation they again avoid the laws –
so can receive compensation based on performance:
c. ??UNLESS all qualified investors in fund – invests 750K or net worth over 1.5MN – then advisor
can take performance based fee;
v. Advisors act contains restrictions on self-dealing – can’t do transactions which defraud, can’t buy/sell
securities on other side of trade w/o disclosing – so can’t tell client to sell and you as advisor are buying it;
can’t have direct dealings w/ client?
vi. ALSO Venture Capital EXEMPTION – same section as hedge fund exemption discusses business
development exemptions – but VCs are illiquid investments but long term, unlike hedge funds very liquid – so
some hedge funds told clients locked into investment so reorg more like venture capital;

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