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I. DEFINITIONS .................................................................................................................... 6 SECTION 2. DEFINITIONS ....................................................................................................... 6 RULE 405 ............................................................................................................................... 7 II. SECURITIES TRANSACTIONS............................................................................................. 9 CHAPTER 1. CHAPTER 1.1 INTRODUCTION ......................................................................................... 9 SECURITIES MARKETS AND PARTICIPANTS .................................................. 9

CHAPTER 1.1.1 PRIMARY AND SECONDARY MARKETS ................................................. 9 CHAPTER 1.1.2 FUNCTIONS OF SECURITIES MARKETS .................................................. 9 CHAPTER 1.1.3 PARTICIPANTS ................................................................................... 10 CHAPTER 1.1.4 INTERCONNECTION AMONG FINANCIAL MARKETS .............................. 10 CHAPTER 1.2 III. CHAPTER 1.3 EFFICIENCY OF PUBLIC STOCK MARKETS .................................................. 10 FEDERAL SECURITIES REGULATION OVERVIEW ...................................... 12 SECURITIES REGULATION .............................................................................................. 12 CHAPTER 1.3.1 SECURITIES ACT OF 1933 ................................................................... 12 CHAPTER 1.3.2 SECURITIES EXCHANGE ACT OF 1934 ................................................. 12 CHAPTER 1.3.3 SPECIALIZED SECURITIES LAWS ......................................................... 13 CHAPTER 1.3.4 SARBANES-OXLEY ACT OF 2002 ........................................................ 13 CHAPTER 1.3.5 SECURITIES AND EXCHANGE COMMISSION ......................................... 14 CHAPTER 1.4 CHAPTER 1.5 CHAPTER 11. IV. STATES SECURITIES REGULATION BLUE SKY LAWS ................................ 15 SEC EXEMPTIVE POWER........................................................................... 15 REGULATION OF SECURITIES INDUSTRY ................................................. 16

CHAPTER 11.1 CAPACITIES OF SECURITIES PROFESSIONALS ............................................. 16 SECURITY ....................................................................................................................... 17 DEFINITION OF A SECURITY .................................................................... 17 IMPLICATIONS OF DEFINITION ................................................................... 17 TESTING FOR A SECURITY ......................................................................... 17 CHAPTER 2.1 CHAPTER 2.2 CHAPTER 2.

CHAPTER 2.2.1 INVESTMENT CONTRACTS (CATCH ALL) THE HOWEY TEST .............. 17 CHAPTER 2.2.2 RISK CAPITAL TEST ........................................................................... 17 CHAPTER 2.3 SECURITIES IN VARYING CONTEXTS .......................................................... 18 1

CHAPTER 2.3.1 REAL ESTATE AS SECURITIES ............................................................. 18 CHAPTER 2.3.2 BUSINESS INTERESTS AS SECURITIES .................................................. 18 CHAPTER 2.3.4 NOTES AS SECURITIES ....................................................................... 18 CHAPTER 2.3.6 STOCK AS A SECURITY ................................................................... 20 V. DISCLOSURE AND MATERIALITY.................................................................................... 21 CHAPTER 3. CHAPTER 3.1 MATERIALITY ......................................................................................... 21 DEFINITION OF MATERIALITY ................................................................... 21

CHAPTER 3.1.1 SUBSTANTIAL LIKELIHOOD TEST .................................................... 21 CHAPTER 3.1.2 REASONABLE INVESTOR .................................................................... 21 CHAPTER 3.1.3 RELATIONSHIP OF MATERIALITY AND DUTY TO DISCLOSE .................. 21 CHAPTER 3.2 MATERIALITY TYPES OF INFORMATION .................................................. 22 CHAPTER 3.2.1 HISTORIC INFORMATION .................................................................... 22 CHAPTER 3.2.2 SPECULATIVE INFORMATION .............................................................. 23 CHAPTER 3.2.3 FORWARD-LOOKING STATEMENTS ..................................................... 23 CHAPTER 3.2.4 INFORMATION ABOUT MANAGEMENT INTEGRITY ............................... 24 CHAPTER 3.2.5 SOCIAL/ENVIRONMENTAL DISCLOSURE.............................................. 25 CHAPTER 3.3 MATERIALITY IN CONTEXT: TOTAL MIX OF INFORMATION...................... 25 CHAPTER 3.3.1 TOTAL MIX TEST ........................................................................... 26 CHAPTER 3.3.2 SAFE HARBORS FOR FORWARD-LOOKING STATEMENTS ...................... 27 VI. REGISTRATION OF SECURITIES OFFERINGS ................................................................... 29 CHAPTER 4.1 REGISTRATION OF SECURITIES OFFERINGS ................................................ 29 CHAPTER 4.1.1 TYPES OF PUBLIC OFFERINGS............................................................. 29 CHAPTER 4.1.2 PRICING AND COMMISSION IN A PUBLIC OFFERING ............................. 29 CHAPTER 4.1.3 DOCUMENTATION IN A PUBLIC OFFERING........................................... 30 CHAPTER 4.2 REGISTRATION OF PUBLIC OFFERINGS ....................................................... 31 CHAPTER 4.2.1 SECTION 5 OF THE SECURITIES ACT .................................................... 31 CHAPTER 4.2.2 CONTENTS OF REGISTRATION STATEMENT ......................................... 32 CHAPTER 4.2.3 PREPARATION OF REGISTRATION STATEMENT ................................... 33 CHAPTER 4.2.4 SEC REVIEW OF THE REGISTRATION STATEMENT ............................... 33 SHELF REGISTRATION .................................................................................................. 34 CHAPTER 4.2.5 PURCHASES DURING REGISTRATION .................................................. 35 CHAPTER 4.3 MANAGED DISCLOSURE DURING REGISTRATION GUN JUMPING ........... 36 CHAPTER 4.3.1 PRE-FILING PERIOD............................................................................ 37 2

CHAPTER 4.3.2 WAITING PERIOD (AFTER FILING, BEFORE EFFECTIVENESS) ............... 40 CHAPTER 4.3.3 POST-EFFECTIVE PERIOD.................................................................... 42 VII. REGISTRATION UNDER THE EXCHANGE ACT ................................................................. 44 CHAPTER 8.3 REGULATION OF PUBLIC COMPANIES ........................................................ 44 CHAPTER 8.3.1 REGISTRATION UNDER THE EXCHANGE ACT ....................................... 44 CHAPTER 8.3.2 PERIODIC DISCLOSURE ...................................................................... 45 VIII. EXEMPTIONS FROM SECURITIES ACT REGISTRATION.................................................... 47 CHAPTER 5. CHAPTER 5.1 CHAPTER 5.2 EXEMPTIONS ........................................................................................... 47 EXEMPT SECURITIES (SECTION 3).............................................................. 47 TRANSACTION EXEMPTIONS (SECTION 4) .................................................. 48

CHAPTER 5.2.1 INTRASTATE OFFERINGS .................................................................... 49 CHAPTER 5.2.2 PRIVATE PLACEMENTS....................................................................... 49 CHAPTER 5.2.3 SMALL OFFERINGS ............................................................................ 51 CHAPTER 5.2.4 REGULATION D ................................................................................. 51 IX. SECONDARY DISTRIBUTIONS .......................................................................................... 53 SECONDARY AND OTHER POSTOFFERING DISTRIBUTIONS ...................... 53 DEFINITIONS OF ISSUERS, UNDERWRITERS, AND DEALERS ......................... 53 CHAPTER 7.1 CHAPTER 7.

CHAPTER 7.1.1 AGENT FOR ISSUER ........................................................................ 54 CHAPTER 7.1.2 PURCHASER FROM ISSUER WITH A VIEW TO DISTRIBUTE .................. 54 CHAPTER 7.1.3 UNDERWRITER FOR CONTROL PERSON............................................ 55 CHAPTER 7.2 SECTION 4(1): TRANSACTIONS NOT INVOLVING AN ISSUER, UNDERWRITER, OR DEALER ............................................................................................... 55

CHAPTER 7.2.1 RULE 144: SECONDARY DISTRIBUTIONS IN PUBLIC MARKETS ............. 56 CHAPTER 7.2.2 EXEMPTIONS FOR SECONDARY PRIVATE PLACEMENTS........................ 57 SECTION 4(3). TRANSACTIONS BY A DEALER .............................................................. 58 CHAPTER 7.3 CORPORATE REORGANIZATIONS AND RECAPITALIZATIONS ........................ 58 CHAPTER 7.3.1 ISSUER EXCHANGES........................................................................... 58 CHAPTER 7.3.2 FUNDAMENTAL CORPORATE TRANSACTIONS RULE 145 ................... 59 CHAPTER 7.3.3 DOWNSTREAM SALES AND SPINOFFS.................................................. 59 CHAPTER 7.3.4 WARRANTS, OPTIONS, AND CONVERSION PRIVILEGES ........................ 59 X. EQUAL ACCESS TO INFORMATION: INSIDER TRADING AND REGULATION FD ............... 60 CHAPTER 10. INSIDER TRADING ................................................................................... 60 CHAPTER 10.1. INTRODUCTION TO INSIDER TRADING ........................................................ 60 3

CHAPTER 10.1.1 CLASSIC INSIDER TRADING .............................................................. 60 CHAPTER 10.1.2 MISAPPROPRIATION OF INFORMATION OUTSIDER TRADING ............ 60 CHAPTER 10.1.3 THEORIES FOR REGULATION OF INSIDER TRADING............................ 60 CHAPTER 10.2 RULE 10B-5 AND INSIDER TRADING.......................................................... 61 CHAPTER 10.2.1 DUTY TO ABSTAIN OR DISCLOSE .................................................. 61 CHAPTER 10.2.2 INSIDER TRADING RULES ................................................................. 64 CHAPTER 10.2.3 OUTSIDER TRADING MISAPPROPRIATION LIABILITY....................... 65 CHAPTER 10.2.4 REMEDIES FOR INSIDER TRADING..................................................... 66 CHAPTER 10.2.5 REGULATION FD (FAIR DISCLOSURE) AND SELECTIVE DISCLOSURE.. 67 XI. LIABILITY UNDER FEDERAL SECURITIES LAWS ............................................................. 69 CHAPTER 6.1 COMMON LAW OF MISREPRESENTATION ................................................... 69 CHAPTER 6.1.1 COMMON LAW DECEIT ...................................................................... 69 CHAPTER 6.1.2 EQUITABLE RESCISSION ..................................................................... 69 CHAPTER 9.5 COMPARISON TO OTHER SECURITIES FRAUD REMEDIES ............................. 70 CHAPTER 9.5.1 EXPRESS FEDERAL REMEDIES FOR SECURITIES FRAUD ....................... 70 CHAPTER 9.5.2 STATE LAW REMEDIES ...................................................................... 75 CHAPTER 9.5.4 ARBITRATION AND PRIVATE ORDERING ............................................. 76 THE DUE DILIGENCE DEFENSE .......................................................................................... 77 RULE 176 REASONABLE INVESTIGATION ................................................................... 78 ESCOTT V. BARCHRIS CONSTRUCTION CORP. ............................................................... 78 IN RE WORLDCOM, INC. SECURITIES REGULATION ....................................................... 80 CHAPTER 12. PUBLIC ENFORCEMENT ........................................................................... 82 CHAPTER 12.1 SEC INVESTIGATIONS .............................................................................. 82 CHAPTER 12.1.1 INVESTIGATIONS: FORMAL AND INFORMAL ...................................... 82 CHAPTER 12.1.2 INVESTIGATIVE POWERS .................................................................. 83 CHAPTER 12.2 ADMINISTRATIVE ENFORCEMENT ............................................................. 83 CHAPTER 12.2.1 SEC ADMINISTRATIVE ENFORCEMENT POWERS ............................... 83 CHAPTER 12.2.2 DISCIPLINARY POWERS .................................................................... 84 CHAPTER 12.3.3 EFFECT OF INJUNCTION .................................................................... 84 CHAPTER 12.3.4 MODIFICATION OR DISSOLUTION OF SEC INJUNCTIONS .................... 84 CHAPTER 12.3.5 STATUE OF LIMITATIONS ................................................................. 84 CHAPTER 12.5 CRIMINAL ENFORCEMENT ........................................................................ 84 CHAPTER 12.5.1 USE OF CRIMINAL LAW IN SECURITIES ENFORCEMENT ..................... 84 4



CHAPTER 12.5.5 SENTENCING OF INDIVIDUAL AND CORPORATE OFFENDERS .............. 84 CHAPTER 12.5.6 PARALLEL ENFORCEMENT ............................................................... 84


DEFINITIONS SECTION 2. DEFINITIONS (1) Security means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateraltrust 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. (3) Sale or sell shall include every contract of sale or disposition of a security or interest in a security, for value. Offer to sell, Offer for sale, or 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. The terms defined shall not include preliminary negotiations or agreements between (i) an issuer or its affiliates, and any underwriter; or (ii) among underwriters who are or are to be in privity of contract with an issuer or its affiliates. (4) Issuer means every person who issues or proposes to issue any security. (6) Territory means Puerto Rico, the Virgin Islands, and the insular possessions of the United States. (7) Interstate Commerce means trade or commerce in securities or any transportation or communication relating thereto among the several States or between the District of Columbia or any Territory of the United States and any State or other Territory, or between any foreign country and any State, Territory, or the District of Columbia, or within the District of Columbia. (9) Write or Written shall include printed, lithographed, or any means of graphic communication. (10) Prospectus means any prospectus, notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security. Except that (a) a communication sent or given after the effective date of the registration statement (other than a prospectus permitted under subsection (b) of section 10) shall not be deemed a prospectus if it is proved that prior to or at the same time with such communication a 6

written prospectus meeting the requirements of subsection (a) of section 10 at the time of such communication was sent or given to the person to whom the communication was made, and (b) a notice, circular, advertisement, letter, or communication in respect of a security shall not be deemed to be a prospectus if it states from whom a written prospectus meeting the requirements of section 10 may be obtained and, in addition, does no more than identify the security, state the price thereof, state by whom orders will be executed. (11) 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. (12) Dealer means any person who engages either for all or part of his time, directly or indirectly, as agent, broker, or principal, in the business of offering, buying, selling, or otherwise dealing or trading in securities issued by another person. (15) Accredited Investor shall mean: (i) a bank whether acting in its individual or fiduciary capacity; (ii) an insurance company; (iii) an investment company registered under the Investment Company Act of 1940 or a business development company; (iv) a Small Business Investment Company licensed by the Small Business Administration; (v) an employee benefit plan, including an individual retirement account; or (vii) any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor.

RULE 405 Affiliate is a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified. Control (including the terms controlling, controlled by and under common control with) means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise [Management Power].

Person with the power to obtain the signatures of those required to sign a registration statement. [Registration Power] Equity security means any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so. Free writing prospectus means any written communication that constitutes an offer to sell or a solicitation of an offer to buy the securities relating to a registered offering that is used after the registration statement in respect of the offering is filed (or, in the case of a well-known seasoned issuer, whether or not such registration statement is filed). Material, when used to qualify a requirement for the furnishing of information as to any subject, limits the information required to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered. Written communication means any communication that is written, printed, a radio or television broadcast, or a graphic communication as defined in this section.



Securities regulation is provided in federal laws and its objective is to protect investors.

CHAPTER 1.1 SECURITIES MARKETS AND PARTICIPANTS CHAPTER 1.1.1 Two types of markets: (a) Primary market. Sales of securities by issuers to investors. Is divided in public or private placements. y Private Placements. Issue ownership interests to its founding members. Issue stock to venture capitalist in exchange of an ownership position and a management role. Public corporations issue trading-restricted securities (debt) to institutional investors. (b) Secondary market. Buy-sale transactions among investors. Investors liquidate investments by selling securities to other investors in private or public trading markets. Exchange Market is the centralized location where buy and sell orders arrive and where specialists maintain book of orders. Over-the-counter Market is the location where selling and buying occurs between securities firms (on behalf of investors) through electronic means. PRIMARY AND SECONDARY MARKETS



Securities markets have three basic functions: (a) Capital formation. (b) Liquidity. Ability readily to sell and investment instrument (c) Risk Management. Diversity and hedge investments 9

Derivative Securities are financial instruments whose prices are derived from pieces of underlying securities. (a) Put Option. Promise to purchase at the option of the seller. (b) Call Option. Promise to sell at the option of the buyer. (c) Futures Contracts. Agreement to buy or sell a particular commodity at a fixed price on a specific date.



(a) Investors. Persons who seek return of investments. Persons who own securities directly or indirectly. Institutional Investors are persons who own securities on behalf of others (i.e. pension and mutual funds, insurance companies, financial institutions, state and local governments, securities firms and foreign investors. (b) Issuers Individuals (through securitization), corporations, federal agencies, state and local governments, non-profit organizations, and mutual funds. (c) Financial Intermediaries are broker-dealers, investment advisors, investment companies and investment banking firms.



Regulatory competition exists because investors and issuers migrate if the market is too regulated. This is the reason why trading with institutional investors or debt issuance has become more popular. Regulatory overlap states how different regulators assert jurisdiction over the same financial transaction (federal vs. blue sky laws).

CHAPTER 1.2 EFFICIENCY OF PUBLIC STOCK MARKETS Efficient Capital Market Hypothesis Prices of the stock are determined by the public information known and assimilated by the market. Particular information affects the market price of a stock as though everyone had the same information at the same time. (a) Weak Efficiency. Stock patterns random, investors cannot draw charts of past prices nor to extrapolate future prices. 10

(b) Semi-Strong Efficiency. Market promptly impounds all publicly available information. (c) Strong Efficiency. Information impounds as if received by everyone at the same time.



SECURITIES REGULATION CHAPTER 1.3 FEDERAL SECURITIES REGULATION OVERVIEW The federal securities laws grew out of the public outcry for reform of the securities markets, which had lost almost all of their value in the Great Depression. From 1932-1934 the Senate Banking Committee held hearings on securities market practices. President Franklin D. Roosevelt started his administration in 1933 and had the burden to fill the gaps in state law and Wall Streets self regulation. CHAPTER 1.3.1 SECURITIES ACT OF 1933

The Securities Act was the first bill drafted by the Federal Trade Commission Commissioner Huston Thompson. The Thompson Bill focused on informed investors rather than government paternalism. The Securities Act was drafted as a disclosure statute over a weekend by a professor and 3 former law students. The final statute maintained the Thompson Bill but inserted a disclosure scheme from the English Companies Act of 1929. Additionally, they drafted far-reaching liability for participants in securities offerings. The Securities Act focused on disclosure through the registration/filing of a Prospectus. Failure to do so carried criminal penalties, administrative sanctions and private civil liability.



The Exchange Act covered a number of fronts: y y y y y y y The creation of the SEC Regulation of the securities industry (Stock Exchange and Securities Firms) Regulation of margin for the purchase of securities Prohibition against price manipulation Periodic disclosure (reports) Regulation on proxy voting in public companies Regulation of insider trading

Integrated Disclosure During 50 years, the Securities Act and the Exchange Act lived in separate worlds regarding disclosure. In 1982, the SEC reached a unified approach to disclosure under both acts. Regulation S-K for non-financial disclosure and Regulation S-X for accounting information.


Audited Financials The Securities Act and the Exchange Act with a philosophy of leaving the responsibility for sound securities practices to self-regulatory private actors, call for financial statements to be audited by public accountants. The Sarbanes-Oxley Act created a new regulatory structure for accountants that audit financial statements. A registry called the Public Company Accounting Oversight Board was created.



(a) Public Utility Holding Company Act of 1935 Break up holding companies in the gas and electric utilities industry. (b) Trust Indenture Act of 1939 Regulation of indentures (agreements) between the issuer of debt securities and the administrator of debt issue (trustee, typically a bank). (c) Investment Company Act of 1940 Regulates investment companies. (d) Investment Advisers Act of 1940 Regulates broker-dealers.



Sarbanes-Oxley is an act that responded to the accounting and corporate scandals of the early 2000s. It seeks to strengthen the integrity of the federal securities disclosure system and to federalize specific aspects of public corporation law.

Pavlovian Response to Enron Enron had to look for new ways to maintain its constantly growing profits due to competition. Its executives devised two main techniques: (a) Enron entered into paper transactions with specialpurpose related entities that created the appearance of revenues on Enrons financial statements, and (2) Enron financed these related entities with loans (secured by its high-priced stock) that were reported as debt on Enrons balance sheet.


In 2001, Enron restated its financials for the previous four years, and reduced its income by $600M and increased its debt by $628M. Bankruptcy soon followed.

Disclosure vs. Corporate Governance Sarbanes-Oxley moved into areas of corporate governance historically within the domain of state corporate law. For example, the provisions that (1) specify the composition and responsibilities of the audit committees, (2) the restrictions on loans to corporate executives, (3) the forfeiture of executive pay after financial restatements, and (4) limitations on trading by executives during blackout periods.

Evaluation of Sarbanes-Oxley Few enforcement actions have been brought under the Act. The business, accounting and legal communities responded heavily to its many requirements. Empirical studies indicate that investors have responded favorably to some of the Acts initiatives. Greater confidence in the information contained in SEC filings certified by company officers.



The SEC is an independent agency, not part of the Presidents cabinet, created under the Exchange Act and embodied with executive, legislative and judicial authority. (a) Executive Authority. The SEC administers and enforces federal law. It has investigative powers and may issue cease-and-desist orders, impose fines, and order disgorgement of profits in administrative proceedings. It may initiate court action or refer matters for criminal prosecution. (b) Legislative Authority. The SEC promulgates (i) rules, regulation and guidelines with force of law, (ii) interpretative releases concerning view points of statutes (no force of law), and (iii) interpretative letters and no-action letters to provide views and guidance to securities transaction planners. (c) Judicial Authority. The SEC has original jurisdiction and appellate jurisdiction (actions taken by the stock exchanges, NASD and other self-regulatory organizations). The SEC is headed by 5 commissioners appointed by the President and confirmed by the Senate.

Regulation and Technology EDGAR (Electronic Data Gathering Analysis and Retrieval) is a computer system to file documents in electronic form. 14

SEC Partnership with Securities Industry The SEC is responsible for the big picture, whereas the day-to-day regulation of securities is handled by firms themselves and by private membership organizations. Performs targeted oversight while others regulate directly.

Plain English Initiative The SEC enforces the Plain English Initiative in disclosure documents for investors.

CHAPTER 1.4 STATES SECURITIES REGULATION BLUE SKY LAWS Blue Sky Laws are state statutes establishing standards for offering and selling securities. Most of such statutes are antifraud rules. There are parallel statutes on state regulation to those on federal regulation. Covered Securities are securities that may not be subject to state regulation. There are 4 categories of covered securities: (a) Listed Securities. Securities listed on a stock exchange or quoted on NASDAQ, no state registration, filings, reports or filing fees are permitted. (b) Mutual Funds. Securities issued by registered investment companies. (c) Private Placements. Sales to QIBs. (d) Exempt Offerings. Unless the exemption anticipates states regulation. On (b)-(d), States may require fees, consent to service of process and filings of sales reports and other documents similar to those filed with the SEC. Class actions involving allegations of securities fraud in publicly traded securities must be litigated exclusively in a federal court. Delaware Carve-out State cases alleging fiduciary breaches under state corporate law may be brought before a state court.

CHAPTER 1.5 SEC EXEMPTIVE POWER SEC may exempt particular persons and transaction from regulation under the federal securities laws. 15

CHAPTER 11. REGULATION OF SECURITIES INDUSTRY Securities professionals (broker-dealers and investment advisers) are subject to an imposing array of regulation to ensure honesty, integrity, competence, and financial capacity for the protection of investors. CHAPTER 11.1 CAPACITIES OF SECURITIES PROFESSIONALS

Securities intermediaries act in three capacities pursuant to the definitions of the federal securities laws: (a) Broker. A broker is any person (without including a bank) engaged in the regular business of effecting securities transactions for the account of others. (b) Dealer. A dealer is any person (without including a bank) engaged in buying and selling securities for his own account as part of his regular business. (c) Investment Adviser. An investment adviser is a person who, for compensation, engages in the business of advising others on investing, buying or selling securities.




CHAPTER 2.1 IMPLICATIONS OF DEFINITION A transaction that involves a security triggers federal and state securities regulation.

CHAPTER 2.2 TESTING FOR A SECURITY Definition in Securities Act - Section 2.



SEC v. W.J. Howey Co. (328 U.S. 293) Supreme Court defines an investment contract as any transaction in which (1) a person invests money (2) in a common enterprise and (3) is led to expect profits (4) solely (predominantly) from the efforts of others. (1) Investment. An investment, which can be cash or noncash consideration, is expected to produce income or profit. (2) Commonality. Horizontal (pools) - Multiple investors have interrelated interests in a common scheme. Vertical Single investor has a common interest with the manager of its investment. (3) Expected profits. The expected returns (either fixed or variable) must come from earnings of the enterprise and must be the principal motivation for the investment. (4) Efforts of others. Returns most derive solely from the efforts of others; however, lower courts have accepted investors efforts may contribute to profits. The efforts of the managers, however, must be predominant (investors mostly passive). CHAPTER 2.2.2 RISK CAPITAL TEST

Used by State courts to identify when their blue sky laws apply to unorthodox transactions. The risk capital test focuses on the extent to which the investors initial outlay is subject to the risks of the enterprise, over which the investor has no managerial control. Neither the commonality nor the profits be derived from the efforts of others are considered in this test. 17


The sale of real estate (without any collateral arrangements with the seller) is not a securities transaction; nonetheless, courts have applied the Howey Test when the marketing to purchasers emphasizes the economic benefits to be derived from the managerial efforts of the promoter from the rental of units. E.g. Developer offers resort condos under an arrangement in which purchasers agree to make their property available for rental, with limited rights of occupancy, and to receive a pro rata share of net rental income from a pool of all rentals in the complex. If there is no pooling of rents and condo purchasers have control over rental arrangements, the property sale does not involve a security.



Whether ownership interests in a typical business organization are securities depends on the legal form: Form Corporation Limited Partnership Partnership (Joint Venture) Security Common and Preferred Shares Limited Partner Interests General Partner Interests Partner Interests Co-venturer interests Not Security



A note evidences a borrowers promise to repay a debt (extension of credit) and, as such, represents the creditors investment in the borrower. A Note is included within the definition of Security under the Securities Act; however, many extensions of credit do not have the typical attributes of an investment. Promissory notes under consumer and commercial financing transactions should not be treated as securities. Under the Securities Act, a note that arises out of a current transaction and that matures within 9 months is exempt from registration under the Act. Such exemption is intended for commercial paper which are unsecured promissory notes issued by large, financially sound companies to finance current operations and sold to institutional investors in large denominations.


In order to know if a note is a security, it is important to focus on the economic realities of the transaction, not merely in the maturity. Reves v. Ernst Young (494 US 56) Family Resemblance Test It begins with a rebuttable presumption that every note is a security unless it falls into a category of instruments that are not securities. Commercial notes are in the family of nonsecurities. Family Resemblance Test provides four factors to determine the family into which a note fits: a. Motivation of seller and buyer. If the issuer uses the proceeds of the note for general business purposes, it is more likely a security. If it uses it to buy consumer goods or for commercial purpose, it is more likely that it is not a security. b. Plan of distribution. If the notes are widely offered and traded, it is more likely a security. If the note is given in a face-to-face negotiation to al limited group of sophisticated investors, it is more likely not a security. c. Reasonable expectations of investing public. If investors generally view the type of notes to be investments, it is more likely a security. d. Other factors reduce risk. If the note is not collateralized and not subject to nonsecurities regulation, it is more likely a security. If the notes are secured or otherwise regulated (such as banking regulation) it is more likely not a security.

Sale-Leaseback Financing A financier agrees to nominally purchase an asset used by a business and receive fixed lease payments for a specific period, after which the lease terminates and the asset must be repurchased by the business. Normally, a sale-leaseback is not viewed as a security, but instead as a form of secured financing. SEC v. Edwards (540 US 389) A sale-leaseback arrangement for payphones can constitute an investment contract under the Howey Test, even when the scheme involves a contractual promise to pay a fixed rate of return. In the case, more than 10,000 people invested in a scheme where purchasers were offered a payphone, along with a five-year agreement for the management and the buyback of the payphone.


An investor contract could involve one that promised a fixed rate of return, even though there was no promise of capital appreciation or participation in business earnings.



Must stocks are securities; however, the underlying economic basis must be analyzed. The term stock is included in the Securities Act definition; however, courts have held that not all instruments labeled stock are securities. Noninvestment Stock United Housing Foundation v. Forman (421 US 837) A security must reflect economic reality. Cooperative housing corporation which required residents to buy shares. Residents were entitled to one vote regardless of the shares they held. At the end, residents were bound to sell their share back to the corporation at its original price. The Court ruled that the shares were not securities since it was not a stock investment since: (1) There was no right to dividends; (2) shares were not negotiable; (3) voting rights were not proportionate to the number of shares held; and (4) the shares could not appreciate in value. Additionally the Courts applied the Howey Test and it lacked the expectation of profits. Sale of Business Doctrine Should a stock purchase acquisition be treated as a securities transaction? Fredricksen v. Poloway (637 F.2d 1147) During the 80s lower courts concluded that the transfer of a majority of the stock of a private company is not a securities transaction. Under the sale of business doctrine, the courts looked to Howeys emphasis on management to conclude that the sale of a majority interest passes complete control to purchaser, who becomes an owner-entrepreneur and not an investor. Golden v. Garafalo (678 F.2d 1139) Stock is stock no matter how it is transacted.




Material information is the only information required by the SEC in order to avoid overload of information without suffering of scarcity.


A fact is material if there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered. Substantial likelihood connotes that the information probably would have been important to a reasonable investor.



The SEC interprets reasonable investors as professional securities analysts, rather than irrational investors. Wielgos v. Commonwealth Edison Co. (892 F.2d 509) The Court held that omitted information about regulatory proceedings that resulted in costly delays for utilitys power plants was not material since securities analysts already knew of the proceedings and their risks.



Just because information is material does not mean it must be disclosed. Duty relates to whether and when information must be disclosed; materiality relates to what information must be disclosed. Unless there is a duty to disclose, the materiality of the information is only of theoretical interest. Disclosure duties under the federal securities laws can arise in essentially 2 ways: (a) SEC Filing Obligations. Companies offering securities to the public and reporting companies that have publicly traded securities must provide line-item disclosure in SEC filings.


Rule 408. SEC requires reporting companies to include in their filings any other material information necessary to make required disclosure not misleading. Rule 12b-20. In addition to the information expressly required to be included in a statement or report, there shall be added such further material information, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading. (b) Duty of Honesty. The antifraud provisions of the federal securities laws require complete honesty concerning material information whenever one speaks in connection with certain securities transactions. The duty of honesty includes (i) not making material false or misleading statements; (ii) to correct materially false or misleading statements, and (iii) to update statements that have become materially false or misleading. If a company does not speak and has no specific duty to speak, the federal securities laws permit management to keep business information confidential (no matter how material).

CHAPTER 3.2 MATERIALITY TYPES OF INFORMATION Despite the prevalence of the substantial likelihood test, the SEC and the Courts take different approaches to materiality:



When disclosure of past information coincides with abnormal changes in public stock prices, Courts assume it was material information. However, it sometimes does not affect because the information already had been absorbed by the market prior to a formal disclosure. Courts reject arguments that materiality depends on particular quantitative benchmarks (i.e. 5% price change).

Off-Balance Sheet Disclosures Sarbanes-Oxley mandates that the MD&A must include off-balance sheet arrangements and known contractual obligations reasonably likely to have a material effect on the companys financial condition.

Market Reaction A common test for the materiality of company information is whether the market price of the companys stock changes on the date the information is first disclosed (whether in a formal report or by the media). Courts have relied on this measure of materiality.




When information is relevant because it portends a future event (mergers, discoveries, etc.), Courts have applied a special version of the substantial likelihood test, the probabilitymagnitude test: Basic, Inc. v. Levinson. Materiality will depend on the financial significance of the event, discounted by the chances of it actually happening. Information is material if its expected value, discounted by its uncertainty, indicates it would affect investor behavior. Companies in merger negotiations may remain silent so long as they do not release false or misleading information.

Puffery One kind of speculative information is an overstatement of present circumstances, based on a hope that events will turn out well. Federal Courts have been reluctant to treat optimistic statements as misleading. Eisenstadt v. Centel Corp. everyone knows that someone trying to sell something is going to talk on the bright side.



Projections, estimates, or opinions that reflect a look into the future is the most valuable and the most perilous for investors.

Voluntary Disclosure of Forward-Looking Information Rule 175. Rule 3b-6. SEC permits forward-looking information in SEC filings unless it is shown the statement was made without reasonable basis or disclosed other than in good faith. This forward-looking information disclosure focuses on a subjective test of what management knows or should know of the future; and an objective test or disclaimers or cautions that accompany future statements.

Mandatory Disclosure of Forward-Looking Information SEC requires the presentation of forward-looking statements in the MD&A of certain SEC filings, such as annual reports and Prospectuses. The MD&A must describe: (a) Trends and uncertainties that are reasonably likely to result in material changes to the companys financial position. The idea is to present information through the eyes of management. 23

(b) Information that keeps management up at night. (c) Description of the quality and potential variability of earnings, so investors know whether past performance is indicative of future performance. (d) Information on the adoption of accounting policies and accounting estimates underlying financial statements.

Actionability of Forward-Looking Statements The SEC and Federal Courts have treated opinions, forecasts, projections, and general expressions of optimism as actionable under the federal securities laws. A forward-looking statement carries a number of testable factual assertions: (1) the speaker genuinely holds his position; (2) there exists a reasonable basis for his opinion; and (3) there is nothing that contradicts the opinion. Forward-looking statements can be seen as false if one of these implicit assertions is false.



Managements experience and integrity are often critical for investment. SEC requires information about [Regulation S-K]: (a) Management Incentives. Compensation, conflicts-of-interest transactions, loans. (b) Management Integrity. Lawsuits involving personal insolvency, criminal convictions, stock fraud. (c) Management Commitment to the Company. Stock ownership, stock pledges as security for personal loans. In Re Franchard, 42 SEC 163 (1964) SEC asserted materiality of information while stopping a securities offering for not disclosing serious defalcations and suspicious stock pledges of the controlling shareholder. Yet, SEC concluded that disclosure of how the board carried out its state-mandated oversight duties was not matter for federal securities laws. In general, federal securities laws mandates disclosure of compliance with other non-securities norms only if non compliance is clear and would have a financial significance. SEC does not require disclosure of executives criminal behavior unless it has resulted in an indictment or conviction in the last 5 years. [Item 401, Regulation S-K] SEC does not require disclosure of fiduciary breaches, unless management misfeasance is clear. 24

SEC has heightened disclosure duties regarding management self-dealing such as disclosure of retirement benefits for board members or officers. Whether a company can withhold material information that it has a duty to disclose where the information incriminates company executives. SEC v. Fehn (97 F.3d 1276) Mandatory securities disclosure is not aimed at undermining the Fifth Amendment privilege since it does not target groups inherently suspect of criminal activities.

Code of Ethics Sarbanes-Oxley requires that every public company (domestic or foreign) disclose whether it has a code of ethics covering its principal executive and financial officers. Such code must promote honest and ethical conduct and reporting and disciplining of code violation. Any waiver of the companys ethic code must be reported promptly on Form 8-K. The NYSE & NASDAQ require that all listed companies have a code of ethics and specify its contents.



SEC disclosure policy focuses on the financial relevance of business information to investors, rather than its social and environmental relevance to the public. Several groups have urged the SEC to include social/environmental and civil rights information as required (e.g. global warming, environmental impact, etc). Reporting companies must disclose pending environmental proceedings (private or public) that involve potential damage, penalties, and litigations costs of more than 10% of current assets [Instruction 5 to Item 103, Reg. S-K] Potential liability need not be disclosed.

CHAPTER 3.3 MATERIALITY IN CONTEXT: TOTAL MIX OF INFORMATION Disclosure is contextual. Information revealed in one part of a disclosure document may be tempered or disclaimed in another part.




Supreme Courts definition of materiality: There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. TSC Industries, Inc. v. Northway, Inc., (426 U.S. 438) An omission is not material (even if the information is important to investors) if reasonable investors already know or can infer the omitted information from other disclosure.

Total Mix in an Efficient Market Securities investors do not depend exclusively on mandatory disclosure. In fact, as discussed in the Efficient Capital Market Hypothesis, SEC filings often merely confirm information that is known to securities analysts and already impounded the market prices; thus, material information that is already known to the market is not actionable. Longman v. Food Lion, Inc. (197 F.3d 675) The court assumed that the market was aware of labor violations since they were widely reported in the press; even though the information came from the companys labor union and was denied by the company.

Wielgos v. Commonwealth Edison Co. (892 F.2d 509) Truth on the Market Doctrine It is possible that false or misleading disclosure on important company matters is not material if professional securities traders who set the market price know the disclosure to be wrong. Optimistic cost estimates disclosure, through lacking reasonable basis, were not materially misleading because professional traders surely deduced what was afoot and knew to discount managements consistently biased optimism. In short, managers can lie if the market knows its dealing with liars. Buried Facts Doctrine Disclosure can be misleading if it contains material information that is inaccessible or difficult to assemble.


Kohn v. American Metal Climax, Inc. (322 F. Supp. 1331) Proxy statement to be materially misleading for prominently disclosing an investment advisers favorable opinion, but burying in an appendix that the adviser had failed to evaluate the firms assets. If a company discloses both accurate and inaccurate information in the same document, the court will consider whether the document as a whole is misleading. DeMaria v. Andersen (318 F.3d 170) Inaccurate graphs that summarize revenues are cured by accurate financial tables. However, truth does not neutralize falsity if the truth is hidden or discernible only by sophisticated investors.



Forward-Looking Statements include (i) projections of revenues and other financial items; (ii) plans and objectives; (iii) statements of future economic performance, including MD&A statements of financial conditions and results of operation; and (iv) assumptions underlying these statements. Federal courts have recognized that cautioning statements that identify risks temper forwardlooking statements, sometimes rendering them immaterial. Bespeaks Caution Doctrine (Judicial Safe Harbor) Cautionary disclosure (beyond boilerplate warnings) can negate the materiality of or reliance on optimistic prediction. A misleading statement can be discredited by an accompanying true statement. Luce v. Edelstein (802 F.2d 49) Offering memorandum warned that the projections were necessarily speculative and not sure to be realized. Kaufman v. Trumps Castle Funding (7 F.3d 357) Hopeful statements in a prospectus that operation would be sufficient to cover all of the issuers debt service were considered immaterial due to extensive cautionary statements included elsewhere in the prospectus.


Private Securities Litigation Reform Act (PLSRA) Safe Harbor (Statutory Safe Harbor) The PSLRA immunizes public companies and their executives from civil liability (but not administrative liability) for forward-looking statements that turn out to be wrong. It applies only to reporting corporations not to Partnerships or LLCs. The PSLRA provides 3 safe harbors: (a) No actual knowledge. The plaintiff fails to prove the defendant had actual knowledge that the forward-looking statement, either oral or written, were false; and immunizes reckless or negligent statements from private liability. (b) Immateriality. The forward-looking statement was immaterial. It allows the bespeaks caution doctrine as a separate basis for immunity. (c) Cautionary Statements. The forward-looking statement is identified as a forwardlooking statement and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected. Safest safe harbor since it does not consider knowledge or materiality. Boilerplate cautions are not applicable. Statutory safe harbors do not apply to IPOs, tender offers, going private transactions, beneficial ownership reports under Section 13(d) or offerings by blank check companies. Asher v. Baxter Intl, Inc. (377 F.3d 727) Courts have stated that forward-looking statements made with actual knowledge of their falsity are actionable, even if they are accompanied by cautionary statements.




(a) Standby Underwriting. The issuer offers securities to the public and the underwriter buys the securities not purchased by the public. (b) Best Efforts Underwriting. Issuer offers and underwriter seeks for investors on a best efforts basis. There may be all or none or minimum percentage underwriting. This form is used by small underwriters not willing to risk buying the offered securities and not being able to sell. (c) Firm Commitment Underwriting. The underwriter buys securities from issuers and resells to the public. Underwriters earn the spread among the price they paid and the price to which they sold the securities. Normally, risk is allocated on an underwriting syndicate under the leadership of a managing underwriter. (d) Auctioning Securities. Investors bid for the number and price of the securities offered. Dutch Auction. When auction finishes, the issuer sets the price at the lowest bid that clears the offering. All of the investors buy at clearance price. The issuer sells to the highest bidders until if fills the offer. Highest bidders get the securities they offered to buy and the clearance price bidders get the remainder on a pro rata basis.



The price of the securities depends on whether there exists and established market for such securities. For securities already offered, the offering price is typically set below the market price to assure the issue clears (save LOBs or Tender Offers). (a) Inefficient Pricing of IPOs. Underwriters underprice IPOs to ensure the issue clears and create profit opportunities for initial purchasers. In the long-term, IPOs are regularly overpriced. Irregular IPO activities: Flipping is when initial investor sells on the first day of an IPO. Spinning is when the underwriter allocates the securities offered to preferential investors for future business. Quid pro quo Arrangements are arrangements where the underwriter allocates securities to investors who at the same time pay big commissions. 29

Laddering is when the underwriter allocates securities offered with the promise of buying the securities back while in the aftermarket.



(a) Letter of Intent. Executed among the issuer and the underwriter. (b) Issuer Housekeeping. Adapt companys structure, capital and financial information to that required by the SEC. (c) Registration Statement. Describes through the means of a Prospectus the issuer and the offering to be made. (d) Comfort Letters. Underwriters demand comfort letters from accountants (typically for unaudited financial statements included in the prospectus) and from lawyers (typically regarding due incorporation, authorization of the offer and issuance of securities and no undisclosed contingencies). (e) Agreement among Underwriters. Agreement among the syndicate of underwriters providing for compensation and liabilities. (f) Underwriting Agreement. Agreement among issuer and managing underwriter providing for specific price, amount of securities to be offered and each participating underwriters allotment. Green Shoe Option (Over-allotment option). Underwriter may buy additional securities from the issuer if demand exceeds the initial offering capped to 15% of the total offering. This option helps stabilize prices if underwriter buys back securities in the aftermarket. (g) Selling-Group Agreements. Agreement among the underwriters and securities firms who will act as retail dealers in the offering.


CHAPTER 4.2 REGISTRATION OF PUBLIC OFFERINGS Before securities can be offered or sold to the public, the issuer must file a registration statement with the SEC and provide investors a detailed Prospectus. The Exchange Act on the other hand, calls for the registration of any class of publicly traded equity securities and operates to register public companies.



(a) Sale or delivery after sale of unregistered securities 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. (b) Necessity of prospectus meeting requirements of section 10 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 carry or transmit any prospectus relating to any security with respect to which a registration statement has been filed under this title, unless such prospectus meets the requirements of Section 10; or 2. to carry or cause to be carried through the mails or in interstate commerce any such security for the purpose of sale or for delivery after sale, unless accompanied or preceded by a prospectus that meets the requirements of Section 10(a). (c) Necessity of filing registration statement 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.


Section 5 separates registration process in to 3 periods: (a) Prefiling Period. Issuer prepares for the offering. (b) Waiting Period. Registration statement is filed with the SEC, but is not yet effective. (c) Posteffective Period. Period after the registration statement has become effective and until the offering finishes.



Section 7 provides that the registration statement of a security to be offered by a domestic issuer must contain and be accompanied by the documents specified in Schedule A. Regarding foreign issuers, the information and documents provided in Schedule B. If any person whose profession gives authority to a statement made in the registration statement, the written consent of such person shall be filed with the registration statement. The registration forms under the Securities Act vary in the detail they require, as well as the latitude they give registrants to incorporate by reference information contained in other SEC filings. The forms are the following: Form S-1 (F-1 for foreign issuers) Form S-1 is the most detailed set of instructions and must be used by non-reporting issuers (making and IPO), or small or unseasoned reporting issuers. Regarding reporting issuers, information may be incorporated by reference if they are current with their Exchange Act filings. Form S-3 (F-3 for foreign issuers) Available to large, seasoned companies that have been reporting for at least 1 year and, if offering new securities, that have a public float of at least $75M. Public Float is the aggregate market value of the companys equity securities held by public investors who are not insiders or affiliates of the company. Also available to issuers (that are not shell companies) with less than $75M public float if (i) have been a reporting company for 12 months, (ii) their common stock is listed on a national stock exchange, and (iii) they issued more than 1/3 of their public float in a 12-month period. The form permits the prospectus to incorporate by reference information from the companys annual report and other period reports under the Exchange Act. Investors only receive a prospectus describing the particular offering.


Form S-4 Special form for securities issued as a result of a merger or acquisition.

CHAPTER 4.2.3 Prospectus:


(a) Must contain SEC requirements and must disclose information. (b) Is a selling document, thus it must contain information of the issuer and of the securities being offered. (c) Must be written with an eye to litigation (litigation document).

Rule 421. Presentation of Information in Prospectuses (a) Information may be provided in any order, however, must be set forth in such a fashion as to not obscure any of the required information or any information necessary to keep the required information from being incomplete of misleading. (b) Plain English must be used in the front and back pages, the summary, and the risk factor section of the Prospectus; however, plain English is normally used throughout the whole Prospectus. Plain English 1. 2. 3. 4. 5. 6. Short Sentences. Everyday language Active voice Tabular presentation of complex material No legal jargon No multiple negatives



Under Section 5, securities may be sold once the registration statement becomes effective. The statutory scheme of the effectiveness of the Registration Statement is as follows: (a) Effectiveness. The registration statement becomes effective automatically 20 days after its filing, unless the SEC determines an earlier effective date.


(b) SEC Review. After the filing, the SEC has 10 days to review the registration statement for incomplete or misleading disclosure and may issue a refusal order that keeps the registration statement from becoming effective. (c) SEC Oversight. Before or after its effectiveness, the SEC can begin a nonpublic administrative investigation. After its effectiveness, the SEC may issue a stop order if it notices a defect in the disclosure. No offering activities are permitted when a refusal or stop order is outstanding or the SEC is investigating a registration statement. In practice, the SEC rarely issues refusal or stop orders, rather it issues delaying amendments to the registration statement. Rule 473. To accomplish SEC complete review, registrants stipulate to a delaying amendment in their registration statements, creating a charade that the issuer is continuously amending the registration statement, thus continuously delaying effectiveness until (i) an amendment is filed by the issuer providing that such registration statement shall thereafter become effective; or (ii) the registration statement becomes effective as determined by the SEC. The SEC makes the registration statement effective when the issuer addresses its comments, and is satisfied that (i) disclosure is adequate; (ii) there has been sufficient circulation of the preliminary prospectus with underwriters and potential investors; (iii) underwriters meet the net capital requirement under the Securities Act; and (iv) the NASD does not disapprove pricing or concessions to securities firms participating in the offering.

SHELF REGISTRATION Rule 415. Shelf Registration permits registration of securities for later sale if the registrant undertakes to file a post-effective amendment disclosing any fundamental change in the information provided in the original registration statement. Conditions: (a) If issuer does not qualify for forms S-3 or F-3, shelf registration is only available for offerings involving preexisting obligations, business combinations, and continuous offerings lasting more than 30 days. (b) Only issuers who qualify for forms S-3 or F-3 may delay their offerings and choose when to sell off the shelf. (c) Time Limit. a. Indefinitely for shelf offering involving preexisting obligations b. 2 years for business combinations 34

c. 3 years for mortgage-backed debt offerings, continuous offerings lasting more than 30 days, and offering by S-3/F-3 issuers. (d) S-3/F-3 must register every 3 years. Any unsold allotments under an old registration statement may be rolled over into the new registration statement. (e) Issuers must update public information when securities are taken off the shelf. Issuers must file a prospectus if there are fundamental changes or when securities are taken off the shelf more than 9 months after the effective date. Updating requirements do not apply to S-3/F-3 issuers if their information is in an Exchange Act filing incorporated by reference or a prospectus supplement is filed under Rule 424(b). Well Known Seasoned Issuers (WSKIs) may file an Automatic Shelf Registration which registration statement becomes effective when filed with the SEC, without SEC review. WSKIs can register an unspecified amount of securities and only need to name the class of securities to be offered and even add new classes of securities to the offering, without filing a new registration statement. To take securities off the shelf WSKIS must only file a prospectus supplement that includes any omitted information, within 2 business days after the offer is priced and sold.

Withdrawal of Registration Rule 477 permits easier movement among public to private markets and vice versa. The withdrawal is automatically effective upon filing unless the SEC objects within 15 days. Rule 155(c) If the public offering is abandoned before any sales, the issuer can wait 30 days and made a private offering. Rule 155 (b) An issuer that has begun and abandons a private offering before making any private sales may commence a public offering by (1) disclosing this in its prospectus; (2) waiting 30 days to file the registration statement if any offers had been made to non-accredited investors.



Regulation M prohibits price manipulation during a distribution by forbidding each participant in a distribution from bidding or purchasing securities that, because of their terms, can affect the price of the securities being distributed. Regulation M exempts purchases by securities firms participating as underwriters, if the issuer is a large public company and its securities are actively 35

traded. It also creates an important exemption to the prohibition against purchases during a distribution and permits stabilizing purchases. The stabilizing purchases must be for the purpose of preventing a decline in the market place.

CHAPTER 4.3 MANAGED DISCLOSURE DURING REGISTRATION GUN JUMPING Violations of Section 5 during the registration period are known as gun jumping. Section 5 provides: (a) You cannot make offers until a registration statement is filed with the SEC. (b) Once the registration statement is filed, you cannot use a prospectus unless it satisfies the conditions of Section 10. (c) You cannot make sales or deliveries until the registration statement becomes effective, and then the deliveries must be accompanied by a final prospectus. Three periods under Section 5: (a) Pre-filing Period. After the company is in registration, but before the registration statement is filed. Quiet Period. No offers, no sales, no deliveries. (b) Waiting Period. After the registration statement is filed, but before it becomes effective. No sales, no deliveries, no prospectus (unless it complies with Section 10(b)). (c) Post-effective Period. After the registration statement becomes effective, until the distribution ends and the issuer is no longer in registration. No prospectus (unless it complies with Section 10), no delivery unless accompanied by a prospectus.

Jurisdictional Means Section 5 reaches only activities that use means or instruments of transportation or communication in interstate commerce or of the mails. State offers may exist, but it would be almost impossible to carry out a public offering without using jurisdictional means. Kerbs v. Fall River Industries, Inc. (502 F.2d 731) Intrastate phone calls involve the use of an instrument of communication in interstate commerce. Additionally, payment of securities by check will be construed as instrument of communication in interstate mails.


Electronic Offerings Issuers and securities firms provide information to investors using electronic means. The SEC has also certified that merely including information on a Web site in close proximity to a Section 10 prospectus does not, by itself, make the information an offer to sell. An issuer can even become responsible for third-party information if its Web site links to that information.

Issuer Categories under the 2005 Reforms The 2005 Public Offering Reforms identify 4 categories of issuers. The activities permitted during the registration period vary greatly depending on which category the issuer falls because of the degree of market presence of the issuer: (a) Non-reporting issuer. Not required to file under the Exchange Act. (b) Unseasoned reporting issuers. Required to file under the Exchange Act, but not eligible for Form S-3. (c) Seasoned reporting issuers. Required to file under the Exchange Act that are eligible to Form S-3 (more than one year since going public and a $75 million public float). (d) Well-known seasoned reporting issuers (WKSIs). Seasoned reporting issuers that have either (i) $700 million worldwide public float; or (ii) if issuing non-convertible debt, $1 billion in debt issues in the last 3 years. Distinction due to efficiency of the market. Reporting companies that are not current with Exchange Act filings, blank-check companies, penny-stock issuers and shell companies are ineligible to use the communication exemptions.

CHAPTER 4.3.1 Prohibitions


(a) No sales or deliveries. No disposition of a security for value. (b) No offers. No offer to sell or offer to buy. Section 2(a)(3) defines offer as every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.


SEC release: any publicity that may contribute to conditioning the public mind or arousing public interest in the offering constitutes an offer; considering the following factors: i. ii. iii. iv. Arranged after a financing decision Was broadly disseminated Included forward-looking information of the issuer or its business Mentioned the planned offering

In re Carl M. Loeb, Rhoades & Co. (38 SEC 843) Disciplinary proceeding against 2 underwriters that issued press releases concerning a company that proposed a public offering before the company had filed a registration statement. The underwriters were sanctioned for violating Section 5 and arousing and stimulating investor/dealer interest. Permissions (except Investment Companies) (a) Preregistration Communications (Rule 163A). Communications by or on behalf of an issuer (other than prospective underwriters or dealers) are permitted when made more than 30 days before the registration statement is filed, provided that (i) the proposed offering is not mentioned, and (ii) the issuer must take reasonable steps to ensure these preregistration communications are not further distributed or published within the 30-day period. (b) Regularly-Released information (Rule 169). Not initiate publicity, but continue to advertise products and services, to make periodic and other disclosures under the Exchange Act, issue factual press announcements, and respond to regular inquiries. All while avoiding future-looking statements and valuation opinions. Dissemination must be intended to persons other than investors (the public). Rule 168. Reporting companies can also continue to release forward-looking information about the companys operations and finances, including to investors. Limited to regularly-released information. It is a use safe harbor, an issuer cannot use this information in a road-show or as offer material. Release 5180. Issuers may continue ordinary course communication, including advertising products, filing Exchange Act reports, without including forward-looking statements (except Rule 168). (c) Preliminary Negotiations. Negotiations between issuers and potential underwriters. Includes financial due diligence of issuer by underwriter. Talks to internal sales people of the underwriter. (d) Research Reports. SEC safe harbor rules give guidance to securities firms and their analysts to permit the flow of information to securities markets when an issuer is in registration:


a. Nonparticipant research reports (Rule 137). Securities firm not participating in the distribution: (i) the report is in the regular course of the firms business; (ii) the issuer is not a blank-check, shell or penny-stock company, and (iii) the securities firm has received no special compensation directly or indirectly from the issuer (or a potential investor) related to the report. b. Issuers non-offered securities (Rule 138). Securities firm (even participating in the distribution) may publish reports about the issuers (reporting issuer or foreign issuer; not a blank check, shell or penny stock) common stock (or preferred stock convertible into common stock), if the offering is for fixed-income securities and vice versa; provided that reports are in the regular course of the firms business. c. Participant research reports (Rule 139(a)(1)). Securities firm participating in the distribution may issue company-specific research reports if it appears in a regular publication and either (i) the issuer is a seasoned reporting company eligible for Forms S-3 or F-3: (ii) a WKSI; or (iii) a foreign issuer either seasoned on a foreign stock market or has a $700 million global public float. Securities firm must have covered the issuer or its securities, and cannot reinitiate coverage during registration. May as well issue industry research reports that include reporting companies that are in registration (Rule 139(a)(2). Must have had included the issuer in previous reports and include a substantial number of other issuers, giving no greater prominence to the issuer. (e) Company Announcements (Rule 135). The issuer or security holders may, directly or indirectly, announce (i) the amount and type of security to be offered, and (ii) the timing, manner, and purpose of the offering. May not include information regarding prospective underwriters or pricing and must contain a legend that such notice does not constitute an offer. Available until the filing becomes effective. Chris-Craft Industries, Inc. v. Bangor Punta Corp. (426 F.2d 569) Announcement by underwriter that company would offer a package of security valued at $80 or more violated Section 5 because it went beyond disclosure permitted by Rule 135. (f) WKSI Communications (Rule 163). WKSI may make oral offers during registration and can make written offers that bear a legend (where to get prospectus, along with admonition to read it) and are filed with the SEC Free Writing Prospectus. WKSI communications remain subject to antifraud regulation and selective disclosures under Regulation FD. Available until filing.


CHAPTER 4.3.2 Prohibitions


(a) No sales or deliveries. No disposition of a security for value. The common practice is for participant in an offering to collect indications of interest from investors, but not to take checks or otherwise accept orders. Condition precedent upon effectiveness of filing is not acceptable in Purchase Agreements. (b) No prospectus. No use of prospectus unless it meets the requirements of Section 10. Prospectus means any communication written or by radio or television, which offers any security for sale. A selling effort in writing. Permissions (a) Oral Offers. Oral selling offers are subject only to antifraud prohibitions. Allowed under a constitutional perspective (Freedom of Speech; even though that in the Prefiling Period is not allowed). (b) Preliminary Prospectus. Section 10(b) authorizes the SEC to permit the use during the waiting period of an incomplete prospectus. Rule 430 (in connection with Section 10(b)) allows a preliminary or red herring prospectus which includes a marginal legend that cautions the securities cannot yet be sold. The preliminary prospectus includes all information except pricing and underwriting. (c) Summary Prospectus (Rule 431). Rarely used. (d) Tombstone Ads. Advertisements (typically made in the financial press using tombstonelike border) that state from whom a prospectus may be obtained and do no more that identify the security, states its price, and name the underwriters. (e) Identifying Statements (Rule 134). You can give specified written information about the issuer, the underwriters, and the offering (more detailed than a tombstone ad) if it includes a legend that the registration statement is still not effective and explain who is selling the securities and where to obtain a preliminary prospectus or hyperlink a preliminary prospectus. (f) Free writing prospectus. Any written or graphic communication by the issuer or in its behalf (including web postings, mass e-mails, but not live PowerPoint presentations) that satisfies certain conditions: (professor Def: its a second type of 10 (b), not a 10 (A) nor (B) or a sale literature) ( no content are required in it ). a. Consistent Information and Legend (Rule 433(c)(1)). May include information beyond that found in the prospectus, but it must not conflict it or other information filed with the SEC. Rule 433(c)(2) Must include a legend 40

that advises reading the prospectus and how to obtain a copy. ( cant conflict with ) b. Filing (Rule 433(d)). Must be filed with the SEC. No later than the day of first use (if prepared by the issuer). No filing requirement if prepared by the underwriter and shown in a face-to-face basis with clients. c. Prospectus Accompaniment (Rule 433(b)(2)). For non-reporting and unseasoned issuers it must be preceded by a preliminary prospectus (Section 10(b)) or the hyperlink to access it (in IPOs it must include price range). For seasoned and WKSIs, the prospectus accompaniment condition is eliminated. A communication that satisfies these conditions is deemed a prospectus under Section 10(b) and may be used during the waiting period. Subject to liability under Section 12.

Rule 164

Post-filing free writing prospectuses

A free writing prospectus of the issuer or any other offering participant, including any underwriter or dealer, after the filing of the registration statement will be a section 10(b) prospectus for purposes of Section 5(b)(1).

Rule 433(f)

Free writing prospectuses published or distributed by media.

Any written offer for which an issuer or any other offering participant provided, authorized, or approved information that is prepared and published or disseminated by the media would be considered at the time of publication or dissemination to be a free writing prospectus. The issuer or other offering participant must file the written communication with the SEC within 4 business days after the issuer or other offering participant becomes aware of the publication.

Prospectus Dissemination It is entirely possible for an investor to get an oral offer during the waiting period, place an order (written or oral) contingent on the registration statement becoming effective, but never receive a preliminary prospectus. SEC has plug this regulatory hole by making prospectus dissemination a condition to acceleration of the effective date: (a) Rule 460. SEC binds the issuer to ensure that preliminary prospectuses have been made available to all participating underwriters and dealers.


(b) Rule 15c2-8(c), (e). In the case of IPOs (non reporting issuers) brokers or dealers shall deliver a copy of the preliminary prospectus to any potential investor at least 48 hours prior to sending a sale confirmation. (c) SEC requires offering participants (if issuer not a reporting company) to send preliminary prospectuses to any investor who is expected to buy (48 hrs. before confirmation of their purchase).

CHAPTER 4.3.3 Prohibitions


(a) No prospectus unless Final Prospectus (Section 10). (b) No deliveries, unless accompanied by Final Prospectus. (c) Written offers must include Prospectus (Section 10). Permissions The regulatory game in the post-effective period is prospectus delivery, considering that access (filing prospectus and its availability in the SEC Web site) equals delivery. (a) Expanded Prospectus types. Section 5(b)(1) permits dissemination of a prospectus that complies with Section 10, however, the SEC allows: a. Not-yet-final prospectus (Rule 430A). Cash offerings can omit price-related and offering-related information, provided it is filed within 15 days after effectiveness. b. Shelf Registration prospectus (Rule 430B) c. Not-yet-final prospectus (Rule 430C). For non-cash offerings. (b) Free Writing (Selling Literature). Communications in the posteffective period which are accompanied by the final prospectus are not deemed a prospectus. (c) Confirmations. Section 2(a)(10) includes any writing that confirms the sale of any security within the definition of prospectus, unless it is accompanied by a prospectus meeting the requirements of Section 10. A confirmation is necessary to finalize sales under Exchange Act rules and applicable state statute of fraud. (d) Securities Deliveries. Section 5(b)(2) requires final prospectus delivery when the securities are delivered. Prospectus delivery can be accomplished with a Rule 173 notice. Access equals disclosure. 42

Form of Final Prospectus The prospectus-delivery requirements were to be satisfied by a full and final prospectus contained in the effective registration statement. To allow flexibility, the SEC now permits the final prospectus to omit price-related information. Issuers have 15 business days after the effective date to the registration statement to file a prospectus containing the price-related information. Rule 173: All that is required is that issuers, underwriters, and participating dealers provide their purchasers a notice which provides that the securities are part of a registered offering within 2 days after completing the sale.

Incorrect Disclosure When posteffective events make the prospectus misleading it is necessary to analyze whether it is a substantive or a fundamental event. If it is a substantive, the registrant can place a sticker on the prospectus with the new information and then file it with the SEC. If the event is fundamental, the issuer must amend the registration statement and wait for the SEC to declare the amendment effective.

Rule 172.

Delivery of prospectuses.

(a) Sending confirmations and notices of allocations. After the effective date of a registration statement, the following communications are exempt from the provisions of section 5(b)(1) and 5(b)(2) of the Act, if the issuer has filed the prospectus with the SEC: (1) Written confirmations of sales (if made pursuant to Rule 10b-10) and other information customarily included (including notices provided pursuant to Rule 173; and (2) Notices of allocation of securities sold or to be sold, including information identifying the securities, pricing, allocation and settlement, and information incidental thereto.

Rule 415.

Delayed or continuous offering and sale of securities.

(a) Securities may be registered for an offering to be made on a continuous or delayed basis in the future, provided, that: (1) The registration statement pertains only to: 43


(x) Securities registered (or qualified to be registered) on Form S-3 or Form F-3 which are to be offered and sold on an immediate, continuous or delayed basis by or on behalf of the registrant, subsidiary or controlling person. REGISTRATION UNDER THE EXCHANGE ACT CHAPTER 8.3 REGULATION OF PUBLIC COMPANIES Companies whose shares are publicly traded must register with the SEC thus making them subject to the Exchange Act regulation: (a) Registered companies must file periodic disclosure documents with the SEC [known as reporting companies]. (b) Registered companies must keep records and maintain a system of internal accounting control. (c) Registered companies are subject to SEC proxy regulation. (d) Any person who makes a tender offer for securities of a registered company must make disclosures to the SEC, to the companys management and to solicited shareholders. (e) Directors, officers, and 10% shareholders of registered companies must disclose their trading in the publicly traded equity securities of the company and are liable to the company if they make profits (or avoid losses) from such trading during a 6 month period after purchasing the securities.



There are 3 triggers that compel a company to register with the SEC and plug itself into the Exchange Acts regulation: (a) [Section 12(a). Listing on Exchange. 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.] (b) Section 12(b). Listing on Exchange. Companies whose securities are listed on a stock exchange are compelled to register with the SEC. (c) Section 12(g). Size Thresholds. Companies whose class of equity securities are held by more than 500 shareholders and have total assets exceeding $10M must register with the SEC. The issuer must register within 120 days after the end of the fiscal year when both thresholds are crossed.


(d) Section 15(d). Registration Statement Filing. Companies who file a registration statement which has become effective pursuant to the Securities Acts, are compelled to register with the SEC. A reporting company may unregister under the Exchange Act pursuant to Rule 12g-4 which provides that: Termination of registration of a class of securities under section 12(g) of the Act shall take effect 90 days, or such shorter period as the SEC may determine, after the issuer certifies to the SEC on Form 15 that the class of securities are held of record by: (a) Less than 300 persons; or (b) Less than 500 persons, where the total assets of the issuer have not exceeded $10 million on the last day of each of the issuers most recent 3 fiscal years.

Rule 12h-3. Suspension of filing made pursuant to Section 15(d).

Exemptions to Registration Companies are exempt from Exchange Act registration, including registered investment companies, state-regulated insurance companies (not listed on a stock exchange or subject to reporting) and non-profit charities. Banks are required to register whether or not they have a listed security.



The three important Exchange Act filings are: (a) Annual Report. Reporting companies must file annually reports within 60 days for large companies, 75 for medium companies and 90 days for small companies of each fiscal year-end on Form 10-K. Disclosure must be extensive. (b) Quarterly Reports. Reporting companies must file quarterly reports within 40 days of each the companies three fiscal quarters on Form 10-Q. Disclosure includes quarterly financial statements and updated risk factors. (c) Special Reports. Reporting companies must file special reports within 4 days of the occurring event on Form 8-K. This Form channels company disclosure material developments into EDGAR on a real-time basis. This Form requires disclosure on the following:


a. Operational Events. Entry into (or termination of) definitive material agreements, loss of significant costumer, bankruptcy or receivership. b. Financial Events. Acquisition or disposition of assets, results of operations and financial condition, direct financial obligations or obligations under an off-balance sheet arrangement, restructuring changes, material impairments under existing agreements. c. Securities-related Events. Delisting or transfer of listing, unregistered sales of equity securities, changes in debt rating, material modifications to rights of securities holders. d. Financial-integrity Events. Changes in registrants certifying accountant, non-reliability of previously issued financial statements or audit report. e. Governance Events. Changes in corporate control, changes affecting directors or principal officers, amendments to bylaws. f. Executive Pay. Compensation agreements, compensation arrangements outside ordinary course of business. Case law provides that (i) if there is a mistake on a Form 10-K, 10-Q or 8-K, the issuer has a duty to correct the wrong statement; and (ii) there is a requirement to update material information, unless you specify in disclosure that no updates will be available. There is a duty to disclose business strategies, only if there is a material active and serious consideration in change of business strategy. Sarbanes-Oxley provides that the SEC must review companies filings at least every 3 years. As commanded by the Sarbanes-Oxley Act, the SEC has adopted rules requiring the CEO and CFO certify that they reviewed the report and that (1) it does not contain any material statements that are false or misleading; and (2) it fairly presents the financial condition and results of operation of the company.




Exempt securities constitute a huge part of the securities markets. Preliminary Points 1. Exempt offerings remain subject to the antifraud provisions of the securities laws (both federal and state). The SEC can proceed against any seller of securities under Section 17 of the Securities Act (Fraudulent Interstate Transactions). 2. Purchasers of securities (other than exempt government securities) may have a private Section 12(a)(2) rescission remedy for misrepresentation in an offering that can be viewed as a public offering. (Gustafson v. Alloyd Co. (513 US 561)) 3. Rule 10b-5 of the Exchange Act which exposes all transactions to fraud liability, including those exempt from registration under the Securities Act. 4. Exempt offerings remain subject to state blue sky registration.

CHAPTER 5.1 EXEMPT SECURITIES (SECTION 3) The first group of Securities Act registration exemptions focuses on the issuer and the type of securities offered. An exempt security is always exempt from registration, both when it is issued and later when traded: Section 3(a)(2) Government Securities. Securities issued or guaranteed by the US Government or any political subdivision thereof (including the Fed). The Government is exempted from disclosure of information regarding is operation and administration. Rule 15c2-12 of the Exchange Act SEC has imposed a disclosure regime on municipal securities and industrial development bonds requiring securities firms to provide investors an official statement for offerings above $1 million. Section 3(a)(3) Commercial Paper. Short-term commercial papers (9 months) that are high quality negotiable notes issued for current business operations and typically purchased by banks and other institutional investors, not offered to the general public. Section 3(a)(4) Securities of Not-for-Profit Issuers. Securities issued so long as none of the issuers net earnings benefit a person, private stockholder, or individual. Religious, educational, benevolent, fraternal, charitable, or reformatory purposes (typically tax-exempt organizations).


Securities subject to Non-SEC Regulation. Exemptions on the basis that other regulations offer adequate protection to investors (e.g. securities issued by banks, insurance policies, pension plans regulated by ERISA, certificates issued by bankruptcy trustees pursuant to court approval, and participation interests in railroad cars of a federally regulated common carrier). Section 3(a)(9) Exchange Securities. Except for securities exchanged in a case under Title 11, any security exchanged by the issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange. Section 3(a)(10) Exchange Securities. Except for securities exchanged in a case under Title 11, any security which is issued in exchange for one or more bona fide outstanding securities where the terms and conditions of such issuance and exchange are approved by any court, or by any official or agency of the United States, or by any State or Territorial banking or insurance commission or other governmental authority expressly authorized by law to grant such approval. Section 3(a)(11) State Only. Any security which is a part of an issue offered and sold only to persons resident within a single State or Territory. Section 3(b) Small Offerings. Securities for less than $5,000,000. Section 3(c) Securities issued by small investment company

CHAPTER 5.2 TRANSACTION EXEMPTIONS (SECTION 4) The second group of Securities Act registrations exemptions focuses on the nature of the offering. The securities not themselves become exempt; each time they are transacted, the seller must find a transaction exemption to avoid registration. Primary Offering by Issuers The transaction exemptions apply to primary offerings by issuers (i.e. Intrastate offerings, private placements, certain small offerings, and exchanges by the issuer). Instead, Section 4(1) market trading exemption, applies to any transaction by a person other than an issuer, underwriter, or dealer. Burden to Establish Exemption The party seeking a transaction exemption carries the burden to prove it. Integration Principle An issuer cannot slice and dice an offering so that different parts fit separate exemptions, if the offering as a whole fits none. In order to trigger integration, it is important to consider whether the multiple transactions (i) are part of a single plan of financing; (ii) involve the same class of 48

security; (iii) took place at about the same time; (iv) involved the same consideration; and (v) were made for the same general purpose. Safe harbors for integration: (a) Rule 502(a). Sets of sales separated by 6 months are considered separate offerings. (b) Rule 152 (private placement and then subsequently initiate a public offering), (c) Rule 155 (shift from a private to registered offering and vice versa). a. Rule 155(a). Permits the issuer that begins a private offering (but sells no securities) to abandon it and begin a registered offering (30-day waiting period unless the private offering was to accredited or sophisticated investors). b. Rule 155(b). From public offering to private offering (30-day waiting period).



Section 3(a)(11) exempts purely local offerings, those by in-state issuers to in-state purchasers. The in-state issuer must be a person resident and doing business within the state of the offering. The issue must be offered and sold only to persons resident within a single State. The transaction remains subject to blue sky laws. Rule 147 (Safe harbor). Provides guidelines on the definition of residence and specifies quantitative guidelines for the doing business requirement. Permits resales after a 9 month holding period. Integration: 6 months apart.



Section 4(2) exempts from registration any offering by any issuer not involving a public offering. Although Congress did not define public offering, courts and the SEC have interpreted the Section 4(2) private placement exemption that registration is unnecessary when investors on their own have adequate sophistication and information to protect themselves. The private placement exemption exists in two forms: (a) Statutory exemption. Section 4(2) (b) Safe harbor rule. Regulation D. 49

Courts have focused on investor qualification, sophistication and access to information about the issuer. SEC v. Ralston Purina Co. (346 US 119) Ralston Purina sold its common stock to employees without registration. Hundreds of employees had bought common stock on their own initiative. The SEC sued demanding that future sales be registered. The Court held that the 4(2) exemption applies when offerees and investors, regardless of their number, are able to fend for themselves. The Court gave as an example executive personnel with access to the same kind of information as would be available in a registration statement. Most of the employees at Ralston Purina were not fit for this description and future sales had to be registered. Investor Qualification Lower Courts have focused on the investors ability to evaluate investment (given his business background) and on his access to information about the investment (based on the availability of information or the issuers actual disclosure). The less sophisticated the investor, the most disclosure is required; the most sophisticated, the less disclosure is required. Hill York Corp v. American International Franchises, Inc (448 F.2d 680) Exemption requires that investors, no matter how sophisticated, have access to information about the issuer. SEC v. Continental Tobacco Co. (463 F.2d 137) Informed investors with no sophistication. The Court suggested qualified investors must have personal contact with corporate officers. Doran v. Petroleum Management Corp. (545 F.2d 893) Investors must have information comparable to that found in a registration statement.

Prohibition Against General Solicitation Public advertising or open investment seminars are prohibited because not all offerees could be shown to be qualified. Resale Restriction Investors who purchase in a private placement cannot resell to unqualified investors. Securities must be treated as restricted securities. Avoided through notations in the securities certificates and restrictions on record keeping. 50

CHAPTER 5.2.3 (A)


Offerings under $5 Million are exempt from registration.

Regulation A (Rules 251-264). Issuer must use an offering circular (simplified disclosure document; financial information is required though may be unaudited) on offerings during any continuous 12-month period having an aggregate price up to $5 million. Available only to nonreporting US and Canadian issuers that are no detailed as bad boys. There are no limitations on general solicitations. Regulation D (Rules 504 and 505) Offerings for less than $1 million and non-public offerings up to $5 million with 35 or fewer nonaccredited investors. (B) Small Business Stock Compensation Plans (C) Small Business Investment Companies (D) Accredited Investors Offerings (Section 4(6)) Self-operative exemption for offerings up to $5 million made exclusively to accredited investors; provided there is no advertising or public solicitation and the issuer files a notice with the SEC. Little use since issuers prefer to use the 4(2) exemption with the 144A safe harbor.



Regulation D gives detailed guidance on when an offering qualifies for the Section 4(2) private placement exemption. Rule 504. Small offerings Registered or Exempt under State Blue Sky Laws ($1 million). Rule 505. Medium-Size Offering subject to SEC Conditions ($5 million). Rule 506. Private Offerings subject to SEC Safe Harbor Conditions (Unlimited amount). Regulation D prohibits general solicitations or general advertising. Securities issued pursuant to Regulation D become restricted securities. Issues under Rule 505 and 506 must be sold to less than 35 nonaccredited investors. All nonaccredited investors must receive specified written disclosure. 51

Issues under Rule 506 add one condition, each nonaccredited investor (alone or with an independent purchaser representative) must have sufficient knowledge and experience in business and financial matters so he can evaluate the merits and risks of the investment. Regulation D offerings are governed by the integration principle. Regulation D creates a safe harbor against integration for offers and sales occurring 6 months apart. Rule 501(a) sets out categories of accredited investors: (a) Institutional Investors. Banks, savings institutions, brokerage firms, insurance companies, mutual funds and certain ERISA employee benefit plans. (b) Big Organizations. Tax-exempt organizations and for-profit organization with more than $5 million in assets. (c) Key Insiders. The directors, executive officers, and general partners of the issuer. (d) Millionaires. Individuals who have a net worth (along with spouse) of over $1 million. (e) Fat Cats. Individuals who have had for two years, and expect to have, an annual income of $200,000 (or $300,000 with spouse). (f) Venture-Capital Firms. Firms that invest in start-up companies to which they make available significant managerial assistance. (g) Sophisticated Trusts. Trusts with over $5 million in assets and run by sophisticated managers. (h) Accredited-Owned Entity. An entity in which all the equity owners are accredited investors. A single nonaccredited investment decision, carried out through different channels, gets counted as one nonaccredited purchaser. The issuer must file a notice (Form D) to the SEC regarding an offering in reliance in Regulation D.




To understand the boundary between regulated distributions and unregulated market trading, it is important to understand the concepts of control securities and restricted securities. Control Securities are those owned by a control person, who the SEC rules refer to as an affiliate of the issuer. When a control person sells his securities to public investors, there is the understandable concern that he can exploit his superior informational position. For this reason, the Securities Act regulates sales by control persons in much the same way it regulates sales by issuers. Restricted Securities are securities originally acquired in a nonpublic distribution, either from the issuer or a control person that may not be resold into a public trading market without registration or another exemption.

CHAPTER 7.1 DEFINITIONS OF ISSUERS, UNDERWRITERS, AND DEALERS Section 4(1) Securities Act. The provisions of Section 5 shall not apply to transactions by persons other than issuers, underwriters, and dealers. Issuer. See Definitions. Dealer. See Definitions. Underwriter. Means any person who: 1. Has purchased from an issuer (or its affiliates) with a view to the distribution of any security This category deals with the resale of restricted securities (or control securities). 2. Offers or sells for an issuer (or its affiliates) in connection with the distribution of any security. This category deals with assistance in de facto distributions (or control securities). 3. Participates or has a direct or indirect participation in any such undertaking. 4. Participates or has a participation in the direct or indirect underwriting of any such undertaking.


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. Distribution as defined by the Courts, means any offer or sale to public investors, either primary or secondary.



One category of underwriter is the person who sells or offers for an issuer. E.g. Investment banker in a best efforts offering who, for a fee, entices investors who then purchase directly from the issuer. Compensation from the issuer is not a condition to be an underwriter for an issuer. SEC v. Chinese Consolidated Benevolent Association (120 F.2d 738) An association of Chinese Americans sought to encourage the purchase of bonds of the Republic of China through mass meetings, newspaper ads, and personal appeals. Without a compensation or specific authorization by the Chinese government, the association remitted subscription applications and payments to the Chinese governments agent in NY. The Court held that these activities constituted transactions by an underwriter and because the bonds were not registered, were illegal under Section 5 of the Securities Act. The Court reasoned that purchasers deserved the information and protection of registration. Even though the association was not an underwriter, the sales efforts by the Chinese government were regulated transactions by an issuer and any steps to their distribution, were subject to regulation.



A second category of underwriter. E.g. Investment banker in a firm commitment offering who purchases from the issuer and resells his allotment to retail dealers or directly to investors. Even if the purchase is through a private placement and then resell is through a public trading market it is considered an underwriter if purchased with a view to resell to public investors (therefore, issuers often place resale restrictions on privately placed securities). When does a purchaser have a view to distribute? If there is an investment intent. An important indication of intent is the holding period before resale.


USA v. Sherwood (175 F.Supp. 480) Two years is sufficient proof of investment intent to avoid underwriter status. The SEC revised Rule 144 in 2008 to provide for a one-year holding period for the unlimited sale of restricted securities held by a non-control person. In the end, the question of whether an investor is an underwriter should turn on whether the investor who resells is likely to be in a better informational position based on a relationship with the issuer than its buyer. Unlike a neutral investor that would like to sell for liquidity rather than for informational reasons. Pledges What if an investor receives securities as a pledge securing a loan, and then resells the securities after the borrower defaults on the loan? SEC v. Guild Films Col. (279 F.2d 485) Holding banks to be underwriters for foreclosing on securities held as collateral for loans to major shareholder. It all depends if the bank that received the securities was expecting that the borrower would default.



Considers a control person which dumps its securities into a public market. The regulatory concern for such activity should be at least as great as that for public offerings by an issuer because the controlling person has presumably the same informational advantages as the issuer. Controlling persons dumping securities are liable as statutory underwriters.




Noncontrolling holders of restricted securities have 3 ways to resell their securities: (a) Wait until the securities have come to rest. (b) Avoid a distribution and sell in an nonpublic transaction (c) Comply with Rule 144 (SECs safe harbor for secondary distributions) Controlling holders of restricted securities have 3 ways to resell as well:


(a) Claim that isolated and sporadic sales into public trading markets are not a distribution (too risky). (b) Avoid using an underwriter either by selling in a nonpublic transaction or by selling directly on their own without assistance (very tricky). (c) Comply with SEC Rule 144 (safest). Persons holding restricted or control shares can also arrange to have the issuer register the shares (possibility covered by contract rights). Registration rights typically come in 3 varieties: (a) Piggyback Rights are rights that require the issuer to register the shares for resale the next time it files a registration statement for other shares; (b) Demand Rights are rights that require the issuer to register the shares when the holder wants them registered; and (c) S-3 Rights are rights which require the issuer, once it is eligible to use Form S-3, to register the shares as part of the S-3 offering.



Most securities professionals view Rule 144 as the exclusive means for control persons to sell into a public market without registration. Rule 144 specifies the conditions when restricted securities and control securities can be resold. Non-Affiliates A non-affiliate who sells restricted securities is deemed not to be an underwriter provided the persons was not an affiliate for the 3 months before the sale. The non-affiliate is subject to a holding period of 6 months for reporting companies current in their periodic filings under the Exchange Act. The holding period is extended to 12 months if the issuer was not a reporting company for the 90 days before the sale or was not current in its periodic filings. Affiliates An affiliate who sells restricted or nonrestricted securities (as well as any person on behalf of such affiliate) is deemed not to be an underwriter provided the sale meets the conditions specified in the rule on holding period, amount sold, information availability, manner of sale, and SEC filing. Rule 144 can be summarized as follows:


(a) Resales of Restricted Securities of Reporting Companies. The Holding Period is 6 months for both affiliates and non-affiliates. Non-Affiliates can resell after 6 months if the issuer is current with its Exchange Act filings; and after 1 year non-affiliates can resell without limitation. Affiliates can resell after 6 months but are subject to: y Amount Cap: Equity: The greater of (i) 1% of outstanding equity securities or (ii) average weekly trading during the 4 calendar weeks. Debt: greater of (i) 1% or (ii) 10% of tranche of debt securities in any 3 month period. Sales Method: (1) Brokers transactions after filing Form 144; (2) not applicable to resale of debt securities. Information: Publicly available information of issuer. Filing: Disclosure on Form 144 if sale is more than 5,000 shares or more than $50,000.

y y

(b) Resales of Restricted Securities of Non-Reporting Companies. The Holding Period is 1 year for both affiliates and non-affiliates. Non-Affiliates can resell after 1 year without limitation. Affiliates can resell after 1 year but are subject to Rule 144 limitations. (c) Resales of Non-Restricted Securities, Control Securities. There is no Holding Period for non-restricted securities held by control persons; but resales of such control securities are always subject to Rule 144 limitations.



The resale of restricted securities in another private transaction is not a distribution and does not trigger underwriter status. Section 4(1) Exemption The Section 4(1) exemption is a Section 4(1) exemption in which there is no distribution under the criteria of a private placement by an issuer, under Section 4(2). Section 4(1) exemption is a shorthand expression for a Section 4(1) exemption when offers and sales are to nonpublic investors. Ackerberg v. Johnson (892 F.2d 1328)


All of the underwriter definitions require a distribution and because the private sale to sophisticated Ackerberg was not a distribution (a term the Court understood to mean a public offering), the transaction was not one by an issuer, underwriter, or dealer.

Rule 144A Rule 144A is the partial codification of the Section 4(1) exemption. The rules guiding condition is that resales of unregistered privately placed securities be to qualified institutional buyers (QIBs), defined generally as any institutional investor with at least a $100 million securities portfolio. In addition, the securities cannot be traded on any US securities exchange or Nasdaq, but rather the rule anticipates the creation of a private market in 144A Securities. Information about the issuer must be available to QIBs. Issuers must either be (i) reporting companies; (ii) foreign issuers with an exempt ADR program in the USA; (iii) foreign governments; or (iv) a company that has undertaken to provide current financial information.



Transactions by a dealer (including an underwriter not participating in the distribution) shall be exempt from Section 5, except: (A) if made within 40 days after the offering to the public, (B) transactions in a security as to which a registration statement has been filed made within 40 days after the effective date (without considering any time during which a stop order is issued), or such shorter period as the SEC may specify, and In the event of IPOs (non reporting issuers) 90 days, instead of 40 days [25 days]. (C) transactions as to securities constituting unsold allotment by such dealer as a participant in the distribution of such securities.


The offer and subsequent exchange of securities, which alter the nature of the investment held by the exchanging securities holder, are treated as an offer and sale under the Securities Act. If the exchange offer is made to public investors, the offering is subject to registration and the regular gun-jumping rules. The Securities Act exempts exchange offers that are made as a no pressure recapitalizations in which the issuer exchanges its own securities with current holders without paying a commission for soliciting the exchange. 58



Rule 145 Reclassification of securities, mergers, consolidations and acquisitions of assets. Rule 145 is designed to make available the protection provided by registration under the Securities Act to persons who are offered securities in a business combination. The thrust of the rule is that an offer, offer to sell, offer for sale, or sale occurs when there is submitted to security holders a plan or agreement pursuant to which such holders are required to elect, on the basis of what is in substance a new investment decision, whether to accept a new or different security in exchange for their existing security. Rule 145 embodies the SECs determination that such transactions are subject to the registration requirements of the Act. A reclassification of securities covered by Rule 145 would be exempt from registration pursuant to section 3(a)(9) or (11) [Exchange Securities] of the Act if the conditions of either of these sections are satisfied. CHAPTER 7.3.3 DOWNSTREAM SALES AND SPINOFFS

Stock splits and stock dividends, though they involve the issue of new securities to existing holders, are not treated as offers or sales for value and are thus excluded from the registration requirements. Spin-offs are considered an offer and a sale subject to the Securities Act (i.e. the distribution of non-public company shares to shareholders of a publicly-owned company as dividends).



The SEC has held that warrants, options, and conversion rights do not represent offers or sales for value unless they are immediately exercisable. If the rights may be exercised immediately, both the rights and the underlying securities must be registered when issued.



EQUAL ACCESS TO INFORMATION: INSIDER TRADING AND REGULATION FD CHAPTER 10. INSIDER TRADING Abstain or disclose duty No statutes defines insider trading, and its regulation remains largely a matter of federal common law. CHAPTER 10.1. INTRODUCTION TO INSIDER TRADING

CHAPTER 10.1.1 CLASSIC INSIDER TRADING Insider trading arises when a corporate insider trades (buys or sells) shares of his company using material (substantial likelihood test), nonpublic information obtained through the insiders corporate position. Three types of persons may be involved: corporate insider (will always have a fiduciary duty), temporary insiders (treated the same way as a corporate insider), and tippees (will have fiduciary duty if the tipper breached its fiduciary duty to tell the tippee (the tippee should reasonable know) and the tipper benefits or has a personal gain).

CHAPTER 10.1.2 MISAPPROPRIATION OF INFORMATION OUTSIDER TRADING Outsider Trading If the insider learns that his company will do something that affects the value of another companys stock, trading on his material, nonpublic information can also be profitable.

CHAPTER 10.1.3 THEORIES FOR REGULATION OF INSIDER TRADING (a) Fairness. It is unfair to those who trade without access to the same information available to insiders. (b) Market Integrity. It undermines the integrity of stock trading markets, making investors leery of putting their money into a market in which they can be exploited. (c) Cost of Capital. It leads investors to discount the stock prices of companies where insider trading is permitted, thus making it more expensive for these companies to raise capital. In markets outside the US, studies show that cost of equity decreases when the market introduces and enforces insider trading prohibitions. (d) Property. It exploits confidential information of great value to its holder.


Policing Insider Trading When unusual trading patterns show up or trading occurs before major corporate announcements, exchange officials can ask brokerage firms to turn over records of who traded at any given time. The exchanges have an Automated Search and Match System. If the exchanges see something suspicious, they turn it to the SEC.



Perceiving a failure by state corporate law to regulate insider trading, federal courts have used Rule 10b-5 to develop a theory of disclosure-based regulation that assumes that existence of fiduciary duties of confidentiality.

CHAPTER 10.2.1 DUTY TO ABSTAIN OR DISCLOSE No person may misrepresent or silence material facts that are likely to affect others trading decisions.

Parity of Information SEC v. Texas Gulf Sulphur (401 F.2d 833) Federal courts have held that anyone in possession of material inside information must either abstain from trading or disclose to the investing public a duty to abstain or disclose However, to impose an abstain or disclose duty to everyone with material, nonpublic information however obtained- would significantly reduce trading in the stock market.

Duty of Confidentiality Rule 10b-5 as an antifraud rule, the Court has held that any person in the possession of material, nonpublic information has a duty to disclose the information (or abstain from trading) if the person obtains the information in a relation of trust or confidence normally a fiduciary relation. The Supreme Court has extended this duty-based regulation to trading by outsiders who breach a duty of confidentiality to the source of the information even though the source is unrelated to the company in whose securities they trade (tipping)


Chiarella v. United States Chiarella was employed in the composing room of a financial printer. Using his access to confidential takeover documents, he figured out the identity of certain takeover targets. Chiarella then bought stock in the targets, contrary to explicit advisories by his employer. The Supreme Court reversed Chiarellas criminal conviction under Rule 10b-5 and held that it did not impose parity of information requirement. The Court held that merely trading on the basis of material, nonpublic information, could not trigger a duty to disclose or abstain. Chiarella had no duty to the shareholders with whom he traded because he had no fiduciary relationship to the target companies or their shareholders.

Dirks v. SEC Dirks was a securities analyst whose job was to follow the insurance industry. When he learned of an insurance companys massive fraud from Secrist, a former company insider, Dirks passed on the information to the firms clients. The clients dumped their holdings before the scandal became public. The Supreme Court held that Dirks did not violate Rule 10b-5 because Secrists reasons for revealing the scandal to Dirks were not to obtain an advantage for himself. For Secrist to have tipped improperly, the Court held, there had to be a fiduciary breach. The Court took the view that a breach occurs when the insider gains some direct or indirect personal gain or a reputational benefit that can be cashed in later.

United States v. OHagan OHagan was a partner in a law firm retained by a third-party bidder planning a tender offer. He purchased common stock and call options on the targets stock before the bid was announced. The Court of Appeals reversed his criminal conviction on the ground that misappropriation did not violate Rule 10b-5. The Supreme Court reversed and validated the misappropriation theory. The Court concluded that the unauthorized use of confidential information is (i) the use of deceptive device under Section 10(b); and (ii) in connection with securities trading. First, OHagan deceived the source that entrusted him the material, nonpublic information by not disclosing his evil intentions a violation of a duty of confidentiality. Second, the fiduciarys fraud is consummated, not when the fiduciary gains the confidential information, but when he uses the information to purchase or sell securities. OHagan trading operated as a fraud on the source in connection with securities trading a violation of Rule 10b-5.


Satisfying the Disclosure Duty SEC v. Texas Gulf Sulphur (401 F.2d 833) Action against Texas Gulf Sulphur Company and 13 individuals alleging violations of the provisions of Section 10(b) and Rule 10b-5. Certain geologists found an extremely rare and mineral productive drilling site on November 1963. From November 1963 to March 1964 certain of the individual defendants said to have received tips' from the geologists and thus purchased TGS stock and calls thereon. Anyone who, trading for his own account in the securities of a corporation has access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone may not take advantage of such information knowing it is unavailable to those with whom he is dealing. Anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending (tipping) the securities concerned while such inside information remains undisclosed. Materiality will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity (Basic Inc. v. Levinson). A fiduciary may trade on confidential information by first disclosing the information to the person to whom he owns the fiduciary duty. Insiders must wait 24 to 48 hours after information is publicly disclosed to give it time to be disseminated through wire services or publication in the financial press.

State of Mind Rule 10b5-1. A person trades on the basis of material, nonpublic information if the trader is aware of the information when making the purchase or sale.

Pre-Existing Trading Plans Rule 10b5-1(c). A person who sets up specific securities trading plan when unaware of inside information can avoid liability even if trading under the plan occurs later when they are aware of inside information. The person must demonstrate: (a) He had entered into the plan when unaware of inside information. (b) The pre-existing trading strategy either (i) expressly specified the amount, price, and the date of trade: or (ii) included a written formula for determining these inputs; or (iii) 63

disabled the person from influencing the trades, providing the actual trader was unaware of the inside information. (c) The trade accorded with the pre-existing strategy. An entity has an additional affirmative defense if (i) the actual individual trading for the entity was unaware of inside information; and (ii) the entity had policies and procedures to avoid insider trading.

CHAPTER 10.2.2 INSIDER TRADING RULES The breach of a duty of trust or confidence occurs when it is owed, directly, indirectly, or derivatively, to the issuer of a security or its shareholders of that issuer, or to any person who is the source of the material, nonpublic information. (a) Insiders. Persons with a corporate position (directors, officers, employees, or controlling shareholders) have the clearest duty. (b) Constructive (or temporary) insiders. Persons who are retained temporarily by the company in whose securities they trade (accountants, lawyers, and investment bankers). Lower courts have included family settings where there are expectations of confidentiality. (c) Outsiders (with duty to source of information). Persons with no relationship to the issuer, when aware of material, nonpublic information obtained in a relationship of trust or confidence. The breach is deemed a deception that occurs in connection with his securities trading. (d) Tippers. Persons who tip are liable as participants in illegal insider trading. The tip is improper if the tipper expects the tippee will trade and anticipates reciprocal benefits (return the favor). There might be subtippees as well. (e) Tippees. Persons without a confidentiality duty, but knowingly trade on improper tips. He is liable if he knows (or has reason to know) that information came from a person who breached a confidentiality duty. (f) Traders in Derivative Securities. The 10b-5 duty extends to traders in derivative instruments (call options). (g) Strangers. A person with no relationship to the source of material, nonpublic information whether from an insider or outsider have no duty to disclose or abstain under Rule 10b-5.


CHAPTER 10.2.3 OUTSIDER TRADING MISAPPROPRIATION LIABILITY Liability arises when a person trades on confidential information in breach of a duty owed to the source of the information, even if the source is a complete stranger to the traded securities.

Misappropriation Theory There can be no 10b-5 trading liability if there is no breach of trust or confidence. The question is who has such duties of trust or confidence and when a duty of confidentiality attaches. Misappropriation theory holds that person commits fraud "in connection with" securities transaction, and thereby violates 10(b) of Securities Exchange Act and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of duty owed to source of information.

Duty of Confidentiality in Misappropriation Cases The breach of duty is clear on established business relationships (lawyer, accountant, etc), however, it is less clear in other business and personal settings. Rule 10b5-2(b). A recipient of material, nonpublic information is deemed to owe a duty of trust or confidence to the source when: (a) The recipient agreed to maintain the information in confidence. (b) The persons involved have a history, pattern or practice of sharing confidences so the recipient had reason to know the communicator expected confidentiality. (c) The communicator of the information was a spouse, parent, child, or sibling of the recipient; unless the recipient can show that there was no reasonable expectation of confidentiality (based on the family relationship).

Rule 14e-3 Misappropriation of Tender Offer Information SEC prohibits trading based on material, nonpublic information about unannounced tender offers. Rule 14e-3 prohibits, during the course of a tender offer, trading by anybody (other than the bidder) who has material, nonpublic information about the offer that he knows (or has reason to know) was obtained from either the bidder or the target. Under Rule 14e-3, different from Rule 10b-5, there is no need to prove that a tipper breached a fiduciary duty for personal benefit. A


tippee may be convicted under Rule 14e-3, even if he has no duty of trust or confidence to the source.

Mail and Wire Fraud Criminal Liability for Misappropriation Misappropriation of confidential information can also be the basis of non-securities criminal liability.

CHAPTER 10.2.4 REMEDIES FOR INSIDER TRADING Insider traders are subject to sanctions and liabilities. Civil Liability to Contemporaneous Traders Insider trading is unfair to contemporaneous traders, thus recovery should be equal to the traders losses typically significantly greater than the insiders gain. Insider Trading and Securities Fraud Enforcement Act of 1988 limits recovery to traders (shareholders or investors) whose trades were contemporaneous with the insiders. Recovery is based on the disgorgement of the insiders actual profits or losses avoided.

Civil Recovery by Defrauded Source of Confidential Information Owners of confidential information who purchase or sell securities can bring a private action under Rule 10b-5 against insider traders and tippees who adversely affect their trading prices. A defrauded company may recover if it suffered trading losses or was forced to pay a higher price in a transaction because the insiders trading artificially raised the stock price.

SEC Enforcement Action The SEC can bring a judicial enforcement action seeking a Court order that enjoins the inside trader or tippee from further insider trading (if likely to recur) and that compels the disgorgement of any trading profits.

Civil Penalties The SEC can also seek judicially imposed civil penalty against those who violate Rule 10b-5 or Rule 14e-3 of up to 3 times the profits realized (or losses avoided) by their insider trading.


Watchdog Penalties The SEC can seek civil penalties against employers and other who control insider traders and tippers. Controlling persons are subject to additional penalties if it knowingly or recklessly disregards the likelihood of insider trading by persons under its control.

Bounty Rewards The SEC can pay bounties to anyone who provides information leading to civil penalties.

Criminal Sanctions The SEC can refer cases to the US Department of Justice for criminal prosecution of those who engage in willful insider trading.

CHAPTER 10.2.5 REGULATION FD (FAIR DISCLOSURE) AND SELECTIVE DISCLOSURE Regulation FD forbids public companies from selectively disclosing material, nonpublic information. Disclosure practices such as giving detailed financial projections to selected securities analysts or reviewing analyst reports before public release, are regulated. Regulation FD applies to issuer disclosures of material, nonpublic information to specified market professionals, as well as security holders who it is reasonable foreseeable will trade on the basis of the information. Rule 100 (a)(1). When the disclosure is intentional issuers must disclose inside information to the investing public, simultaneously with any disclosure to selected analysts or investors. Rule 100 (a)(2). When the issuer discovers it has made an unintentional selective disclosure, the issuer must disclose the information to the public promptly (generally within 24 hours). Rule 100(b). Equal Access rules of Regulation FD have some exclusions: (a) Disclosure occurring in the normal course of business when the recipient owes the company a duty of trust (to advisers, partners, etc). (b) Disclosure to media or government officials (newspaper). (c) Disclosure made in offerings registered under the Securities Act. (d) Disclosure by foreign private issuers. 67

Rule 101. Disclosure must be made broadly, through Internet or by filing a Form 8-K. Rule 102. Regulation FD is enforceable by the SEC only.




One who intentionally makes a material misrepresentation is liable for the losses caused by the others justifiable reliance. The tort of deceit has 5 elements, all of which must be proved: (a) Misrepresentation of Material Fact The misrepresentation must be material, that is, a reasonable person would attach importance to it in deciding whether to enter into the transaction. (b) Scienter The maker of the misrepresentation must have been culpable that is, he either knew or believed the facts were otherwise or lacked a reasonable basis for the representation. (c) Reliance The person who seeks to recover must have actually and justifiably relied on the fraudulent misrepresentation. (d) Causation The pecuniary loss of the person who seeks to recover must reasonable has been expected to result from the reliance. Not only must misinformation have induced the transaction, but the misinformation must have related to the cause of the loss. (e) Damages Recovery includes (i) out-of-pocket damages (the difference between what the person received in the transaction and the purchase price); (ii) consequential damages, and (iii) punitive damages in flagrant cases.



Rescission, an invention of equity, seeks to undo misinformed deals.

Misrepresentation Rescission has traditionally been based on one of two types of misrepresentation:


(a) Material misrepresentation. One that a reasonable person would attach importance in deciding whether to enter into the transaction. (b) Fraudulent misrepresentation. One known to be false or to lack a factual basis.


Courts have held that the choice of action is the plaintiffs, even when the same conduct is covered by both an express private action and an implied 10b-5 action.

Express Actions under the Securities Act Section 11 of the Securities Act provides investors a damages remedy against specified defendants in cases of material misinformation in the registration statement filed in a public offering. Section 12(a)(2) of the Securities Act provides for rescission relief in cases of material misinformation in a public offering outside the registration statement or by statutory sellers not subject to Section 11 liability. Gustafson v Alloyd Co.: It provides no private relief for securities fraud in market trading or private offerings. For private offerings, the only federal private action is Rule 10b-5.

Section 11 Violation

Section 12(a)(1)

Section 12(a)(2) Offer or sale by means of prospectus or oral communication containing materially false or misleading statement. The liability is measured on when the investment decision was made. Public offering (Jurisdictional means). Not to private offerings (Gustafson v. Alloyd). Future compliance or accuracy of statements does not retroactively cure

Untrue statement or Violation of Section 5 (gunmisleading omission of jumping) material fact in registration statement Section 11 has a tracing requirement (easier on IPOs).


Registered offering

Unregistered, offering



the defect. Plaintiff Purchaser of registered Purchaser of unregistered Purchaser of securities securities. Statute permits securities Courts to require posting of a bond to cover defendants costs. Joint and several liability on the issuer, all who signed the registration statement, directors, underwriters and any expert who consents to his opinion being used in the registration statement. Statutory seller (person who solicits for personal gain). Strict liability reaches persons who solicit sales and have control of the offering. Statutory seller (person who solicits for personal gain). The company and the persons who sign the registration statement.



Due diligence defenses for N/A everybody except the issuer. Standard of diligence: Experts (i) for expertised portion, actually and reasonably believes, after reasonable investigation that the information is true (ignorance is no excuse); and (ii) for nonexpertised portion there is no liability. Nonexperts (i) for expertised portion, no reason to believe that information is false (ignorance is an excuse); and (ii) for nonexpertised portion, actually and reasonably believes, after reasonable investigation, that information is true (ignorance is no excuse).

Defense: Reasonable care and no knowledge


No reliance required N/A Defense: Income statement filed 12 months after offering There can be no recovery if defendant proves the

Defense: Purchaser knows untruth or omission


plaintiff knew the alleged information was false. Causation Defense: Negative N/A causation if he can show how other factors besides the misinformation explain the depreciation in value or if the value of stock rises after disclosure (Ackerman v. Oryx Communications, Inc.) Defense: Loss causation. A causal link between the information and the plaintiffs loss.


Damages formula (capped Rescission or recessionary Rescission or recessionary at aggregate offering price) damages if the stock has damages been sold. Purchasers receive a put option.

Limited Liability

Proportional unknowing directors.

liability for N/A outside


Limited liability on underwriters to the amount of their participation in the offering (except for managing underwriter). Limitations Period 1 year after discovery / 3 1 year after violation years after offering (possible 2 years / 5 years if fraud) 1 year after discovery / 3 years after offering (possible 2 years / 5 years if fraud)

Section 15. Liability of Control Persons. Persons who control any person liable under Section 11 or Section 12 are jointly and severally liable to the same extent as the controlled person (i.e. majority shareholders, directors and officers). Defendants have a limited defense if they did not know (and had no reason to know) of the facts of which liability is based. Section 17(a). Liability in SEC Enforcement Action Imposes liability on sellers of securities (whether in a public, private or exempt offering). Liability is imposed on negligent misrepresentations.


The section prohibits the sale of securities using jurisdictional means that (i) employ an artifice to defraud; (ii) obtain money by means of a material misstatement or misleading omission; and (iii) engage in actions that operate as a fraud.

Express Private Actions under the Exchange Act Section 9 of the Exchange Act prohibits schemes to manipulate stock prices and creates a private action for victim of stock manipulation to recover damages. Plaintiff must post a bond to cover defendants attorneys fees. Section 18 of the Exchange Act provides that false or misleading statements made in filings with the SEC trigger a cause of action for investors who can prove they relied on them, subject to a defense of good faith ignorance. Section 10b-5 Typical Cases (a) Securities Trading. A party to securities transactions gives false or misleading information to induce the other party to enter into the transaction, or remains silent when he has a duty to disclose. (b) Corporate Trading. A corporate manager induces his corporation to enter into a disadvantageous securities transaction. (c) Corporate Disclosures. A corporation (without trading) issues false or misleading information to the public about its securities, or it remains silent when it has a duty to disclose. (d) Insider Trading. Corporate insiders either use confidential, non-public information to enter into securities transactions or tip the information to other trade on the tip. (e) Outsider Trading. Outsiders with no relationship to the corporation use confidential information about the company entrusted to them by others and trade on this information. (f) Customer-Broker Disputes. Securities professionals engage in deceptive or other unprofessional conduct in connection with securities trading by or for their customers.
Rule 10b-5 Violation Section 18(a) Section 9(e) Specified manipulative practices (wash sales, matched orders, false or reckless touting, etc). Trading in securities listed on Stock Exchange

Misrepresentation or False or misleading omission of material fact in statement with respect to connection with a purchase material fact in SEC filing or sale of a security Purchase securities or sale of SEC Filing




Purchaser or seller Birnbaum rule: If the plaintiff did not purchase securities, he has no claim.

Purchaser or seller affected securities


Purchaser or seller manipulated securities



Any person who makes Company, directors, Willful participant false or misleading officers, auditors. manipulative conduct statements and induces others to their detriment. Person who makes false statements in filing. Section 20(a) joint and several liability on control person. Suppliers/costumers are not defendants (Stoneridge).



Scienter required Recklessness included. Defense: In Perio Delicto The plaintiff bears substantially equal responsibility for the violation he seeks to redress.

Defense: Good faith and no Required knowledge of falsity participation)



Reliance required (unless Hard reliance required, you N/A case involves duty to speak actually read the SEC or omission) filing. Loss causation: requires the Price affected plaintiff show that the statement alleged misrepresentation or omission resulted in the claimed losses to the plaintiff. Out-of-pocket damages Recovery cannot exceed actual damages, the goal of liability is compensation and effectively precluding punitive damages. PSLRA caps damages according to a formula that seeks to discount Damages reliance caused by Price affected violation by



by Damages sustained result of violation



posttransaction volatility in prices unrelated to any misinformation. Limited Liability Proportional liability for N/A unknowing violators attributable to their share of responsibility. Knowing violators are joint and several. 2 years after discovery / 5 2 years after discovery / 5 years after violation years after violation N/A

Limitations Period

2 years after discovery / 5 years after violation

Criminal Securities Fraud Section 807 of Sarbanes-Oxley creates a crime for fraud in connection with trading in securities or reporting companies, potentially broader than Rule 10b-5. Section 1348 of the Federal Criminal Code provides that any person who knowingly (1) defrauds any person in connection with any security of a reporting company, or (2) obtains by means of false or fraudulent pretenses, representations, or promises, any money or property in connection with the purchase or sale of any security of a reporting company, shall be subject to stiff fines or jail sentences. Only reporting companies and knowingly violations.



State laws provide alternatives to a federal 10b-5 action. Shareholders deceived by corporate managers can claim a breach of fiduciary duty under corporate laws. State blue sky laws provide statutory remedies for fraudulent sales and (sometimes) fraudulent purchases.

Duty of Honesty Malone v. Brincat (722 A.2d 5) Shareholders can sue corporate managers for violating their duty of honesty if they knowingly disseminate false information that results in corporate injury or damage to individual shareholders.


Blue Sky Laws Section 410 of the Uniform Securities Act. Fraudulent sales under provisions modeled on Section 12(a)(2) of the Securities Act. Section 509(b) of the Revised Uniform Securities Act. Private liability arising from fraudulent sales and fraudulent purchases.

Section 509 RUSA Violation

Rule 10b-5

Purchase (or sale) by means of Purchase (or sale) by means of materially materially false or misleading statement false or misleading statement (or silence when under duty to speak) Purchaser or seller Purchaser or seller

Plaintiff Defendant

Purchaser or seller, controlling person, Primary violator person who engages in partners, directors, officers, employees, fraudulent (or deceptive) conduct on which broker-dealers and agents who materially purchaser or seller relies aid in purchase or sale Defense Purchaser (or seller) did not Scienter required know or could not have known in Recklessness included exercise of reasonable care Purchaser (or seller) knows untruth or Actual an reasonable reliance, unless omission. actionable silence or fraud on market No element Deception proximately caused losses or



Causation Remedy

Rescission (upon tender of purchase Rescission, out-of-pocket damages price) or out-of-pocket damages, with contract damages but no attorneys fees interest and attorneys fees. Joint and several and right of pro-rata Joint and several and right of contribution contribution among liable persons

Limited Liability Limitations Period

2 years after discovery / 5 years after 2 years after discovery / 5 years after violation violation

CHAPTER 9.5.4 Arbitration


Shearson/American Express, Inc. v McMahon (482 US 220) 76

Claims of securities fraud can be arbitrated if the parties so agree, despite provisions of the Exchange Act that give federal courts exclusive jurisdiction over claims arising under the Act.

Contracting around 10b-5 Elements Parties can also by private agreement set the standards for judging their behavior. The parties can specify greater protection that provided by Rule 10b-5 with representations and warranties and indemnification clauses.

THE DUE DILIGENCE DEFENSE The Due Diligence defense is a defense to claims brought under Section 11 of the Securities Act. Such standard refers to negligence on the parties involved in the preparation of the registration statement. Due diligence varies in relation to 2 factors: (i) the directors access to inside company information; and (ii) the directors position as a company insider or as a nonemployee outsider. Elements: y y The burden is in the defendants. The defendant must not know that the fact was inaccurate.

Break defendants in two categories:

Expertised Disclosure Expert Reasonable Investigation and did not believe that the statement was untrue Non-Expertised Disclosure Not liable

Non-Expert No reason to believe that the Reasonable Investigation and did not (directors, officers statement was untrue. believe that the statement was untrue and underwriters)

Experts consent in the registration statement to liability under Section 11 when signing the prospectus. Experts are only liable for their expertise information. Importance of prudent man standard. Cannot rely on representations of others, even from management.


RULE 176


In determining whether or not the conduct of a person constitutes a reasonable investigation or a reasonable ground for belief meeting the standard set forth in section 11(c), relevant circumstances include, with respect to a person other than the issuer. (a) The type of issuer; (b) The type of security; (c) The type of person; (d) The office held when the person is an officer; (e) The presence or absence of another relationship to the issuer when the person is a director or proposed director; (f) Reasonable reliance on officers, employees, and others whose duties should have given them knowledge of the particular facts (in the light of the functions and responsibilities of the particular person with respect to the issuer and the filing); (g) When the person is an underwriter, the type of underwriting arrangement, the role of the particular person as an underwriter and the availability of information with respect to the registrant; and (h) Whether, with respect to a fact or document incorporated by reference, the particular person had any responsibility for the fact or document at the time of the filing from which it was incorporated.

ESCOTT V. BARCHRIS CONSTRUCTION CORP. Facts. This action was brought under Section 11 of the Securities Act by purchasers of 5.5% of convertible subordinated fifteen years debentures of BarChris Construction Corporation (bowling lanes constructor). Plaintiffs claim that the registration statement contained material false statements and material omissions. BarChris would charge clients a small down payment and later would collect notes for payment installments. They would then sell the notes to a factor named James Talcott Inc., at a discounted price, and BarChris would guarantee a percentage of payment under the notes (25% at the beginning but 100% at the end). By 1961, BarChris needed cash; therefore it offered the convertible debentures for liquidity. 78

The Court found materially errors in the registration, among others (1) exaggerated 1960 sales figures in audited financial statements due to inclusion of sales of completed alleys not yet in fact sold (and now operated by BarChriss subsidiaries); (2) misrepresentation that BarChris guaranteed 25% of the notes transferred to the factor when in fact it guaranteed 100%, (3) misrepresentation that all loans by corporate officers to BarChris had been paid; (4) misrepresentation regarding the use of proceeds. All defendants, except BarChris to whom, as the issuer, this defense is not available, pleaded the Due Diligence Defense.

Holdings / Rule of Law Outside counsel for the issuer and the underwriter are not to be considered experts within the meaning of Section 11 of the Act. A lawyer is entitled to rely on the statements of his client and that to require him to verify their accuracy would set an unreasonably high standard. CEO had no due diligence defense since he was familiar with the business and was directly involved in negotiating with the factor; therefore, he knew all the relevant facts. Inside directors had no due diligence defense since, as the CEO, they knew of the financings in their favor and besides, there has to be no prove that they actually read the prospectus since by signing it, it gives sufficient proof that it was read and understood. The CFO had no due diligence defense since, as the CEO, he knew all the relevant facts omitted and misrepresented. He read, understood and signed the prospectus. He was a non-expert and was liable for expert and non-expertised information. In-house counsel which was a Director had no diligence defense except for the 1960s figures since it was not his expertise. Outside Director had no due diligence defense since he signed the prospectus without reading it. Outside Director (outside lawyer) had no due diligence defense as a Director. He drafted the registration statement but did not carry out a thorough investigation. Underwriters had no diligence defense since they relied on management and in-house counsel without carrying a due diligence. If they may escape the responsibility by taking at face value representations made to them by the companys management, then the inclusion of underwriters among those liable under Section 11 affords the investors no additional protection. Auditor is an expert and is liable only for the expertise disclosure. They had no due diligence defense since they prepared the financial information in the registration statement. The Auditor didnt follow professional or even internal auditing standards


IN RE WORLDCOM, INC. SECURITIES REGULATION Securities class action arising from the collapse of issuer, a telecommunications giant, investors sought to hold issuer's underwriters liable based on claims that financials incorporated in the registration statements for two bond offerings contained material misstatements and omissions.

Facts. WorldCom announced a massive restatement of its financials on June 25, 2002. It reported its intention to restate its financial statements for 2001 and the first quarter of 2002. According to that announcement, [a]s a result of an internal audit of the company's capital expenditure accounting, it was determined that certain transfers from line cost expenses to capital accounts during this period were not made in accordance with generally accepted accounting principles (GAAP). The amount of transfers was then estimated to be over $3.8 billion. Without the improper transfers, the company estimated that it would have reported a net loss for 2001 and the first quarter of 2002. On July 21, it filed for bankruptcy. The opinion addresses issues related to an underwriters due diligence obligations. It is undisputed that WorldCom executives engaged in a secretive scheme to manipulate the companys public filings concerning its financial condition. The comfort letter is not by law an allegation to have made a reasonable investigation, it is not determinative. There are questions of fact to believe that the underwriter made no reasonable investigation. A comfort letter on unaudited financial statements is required under professional underwriting standards. Comfort letters include a negative assurance representation which states that there were no reasons to believe that the unaudited financial statements were not prepared in accordance with GAAP. The comfort letter did not include such rep. Underwriters counsel caught such omission, told the underwriter and the underwriter did nothing so they would not lose the business. The underwriter was also a bank and had lent money to WorldCom. They wanted the business to follow through despite the omission in the comfort letter.

Holdings / Rule of Law Underwriters are not being asked to duplicate the work of auditors, but to conduct a reasonable investigation. If their initial investigation leads them to question the accuracy of financial 80

reporting, then the existence of an audit or a comfort letter will not excuse the failure to follow through with a subsequent investigation of the matter. If red flags arise from a reasonable investigation, underwriters will have to make sufficient inquiry to satisfy themselves as to the accuracy of the financial statements, and if unsatisfied, they must demand disclosure, withdraw from the underwriting process, or bear the risk of liability. Underwriter cannot blindly rely on experts.


CHAPTER 12. PUBLIC ENFORCEMENT To carry out its mandate under the federal securities laws to protect investors and ensure integrity of securities markets, the SEC has broad investigatory and enforcement powers. SEC enforcement powers and remedies are broader than those in private litigation (i.e. seeking for damages v.s. structural remedies, such as court orders barring persons or companies from the securities business). CHAPTER 12.1 SEC INVESTIGATIONS

The SEC has investigatory powers in a number of settings: 1. Section 18(e) Securities Act. Determine whether to stopping registration of public offerings. 2. Section 19(b) Securities Act. Enforce Securities Act. 3. Section 21(a) Exchange Act. Determine whether any person has violated, is violating, or is about to violate the Exchange Act and its rules, as well as rule of stock exchange, NASD, etc). The SEC has the power to administer oaths, compel sworn testimony and issue subpoenas for the production of documents. SEC investigations may often come public and be relevant to subsequent civil or criminal proceedings. The SECs Division of Enforcement conducts the investigations and litigates in administrative proceedings before the SEC and brings civil actions in federal court. The Division refers possible criminal violations to the US Department of Justice. CHAPTER 12.1.1 INVESTIGATIONS: FORMAL AND INFORMAL The SEC can investigate past violations and ongoing and impending violations. SEC investigations are triggered from many quarters: review of SEC filings, news stories, periodic inspection of broker-dealers and investment advisers, public complaints, etc. Whistleblowers who work with the SEC are protected against employer retaliation. SEC conducts informal investigations without a formal SEC order. Cooperation at this stage is voluntary. A witness who knowingly and willfully provides false information to the staff commits a crime. It is also a crime to knowingly destroy documents with the intention to impair an SEC investigation. If an informal investigation suggests further information to be called for, the SEC can issue a formal order of investigation. Once such order is issued, the SEC can issue subpoenas.


CHAPTER 12.1.2 INVESTIGATIVE POWERS The SEC requires proper purpose and that the information sought is relevant to that purpose, as opposed to provable cause. There is no administration power to enforce a subpoena, but a person who fails to comply and is ordered by a court to do so, can be held in contempt for noncompliance with a courts order. Fourth and Fifth Amendment Constitutional protections protect persons. However, in Braswell v. United States (487 US 99), the Supreme Court held that a one-person corporation may be ordered to produce corporate records even thought those records may incriminate the sole owner. Investigations end with a report of investigation (Section 21(a) reports) stating out the considerations whether it should lead to enforcement action.



The SEC has non-judicial weapons to enforce the federal securities laws by issuing administrative orders or imposing sanctions in its own proceedings.

SEC Enforcement Procedures SEC administrative enforcement actions are typically initiated by an order of proceedings that specifies the charges and provides a period for the respondent to answer. Proceeding that involve and evidentiary hearing are generally conducted by an administrative judge, who is a SEC employee who hears pre-hearing motions, evaluates testimony, and renders written decisions. The ALJs decision is final unless either the SEC staff or the respondent seek review with the SEC. The SEC has full de novo authority to affirm, reverse, modify or remand the ALJs decision.

CHAPTER 12.2.1 SEC ADMINISTRATIVE ENFORCEMENT POWERS The SEC has the following powers: (a) Stop Offering. The SEC can issue a refusal order to prevent a registration statement from becoming effective if on its face it seems to be incomplete or a stop order of an already effective registration statement. (b) Suspend Trading. The SEC can summarily suspend trading for up to 10 days, whether a security is traded over-the-counter or on a stock exchange. After notice and hearing, the SEC can suspend (for up to 12 months) or revoke the registration under the Exchange Act of affected securities on a finding of non-compliance with the Exchange Act or its Rules.


(c) Cease and Desist Order. The SEC can issue (typically after notice and opportunity for hearing) an administrative order compelling any person to cease and desist from committing violation of the securities laws or their Rules. The SEC can enforce the cease and desist order in a federal district court. (d) Compliance Order. The SEC can order compliance (after notice and opportunity for hearing) with its periodic and tender offer disclosure requirements or adjudicate whether the registrants filings are defective. (e) Order Disgorgement and Accounting. The SEC can seek disgorgement (or forfeiture) of any profits by a person who has violated the securities laws, retaining an accountant to calculate the profits generated by the unlawful activity. A disgorgement order is within the discretion of the court. (f) Bar Corporate Officials. The SEC is authorized in a cease-and-desist proceeding to bar officers and directors from serving for reporting companies, if they violated Section 17(a)(1) or any prohibition of fraud in the sale of securities. Before Sarbanes-Oxley, the SEC was required to show the likelihood of future securities violations. CHAPTER 12.2.2 DISCIPLINARY POWERS CHAPTER 12.3.3 EFFECT OF INJUNCTION CHAPTER 12.3.4 MODIFICATION OR DISSOLUTION OF SEC INJUNCTIONS CHAPTER 12.3.5 STATUE OF LIMITATIONS CHAPTER 12.5 CRIMINAL ENFORCEMENT