Securities Regulation Ouline - Bost

Securities Regulation – Bost Fall 05 I. Information regarding new companies and the stock market a. The typical start up company i. Financing 1. Financed primarily by family and friends (informal financing) 1. Selling to family and friends almost always exempt from ‘33 Act b/c private placement 2. Often use stock options with salaries for key employees b/c you can‘t pay as much 1. An option means that you can buy stock at today‘s market price (which is low for new company), but you have options to buy, say for the next ten years. Purpose is to keep employees around. 2. Venture Capital Financing: invest in speculative company at relatively early stage (not necessarily as early as family and friends) 1. Angel Investors: people who have money that they can afford to lose, looking for t hat company that may make it (often want stock options) 2. Institutional Venture Capitalists (soon after the angel investor). This is investment professional who goes out and solicits funds from anyone who wants to allocate moneys to higher form of risk. a. VC funds are limited partnerships: general partner is the company, and the limited partners are those soliciting money from 1. partnership buy stock from corporation in exchange for money b. VC goal: company go public so they can sell shares and get out (not interested in owning, want to take on new venture). Exit strategies: IPO or acquire by other company. 3. Financing Example: WWE 1. WWE stock worth .01, then $17 (this is what entrepreneur wants—opportunity to go public and build company, the have company value demonstrated by stock exchange) 2. First Angel Investors come in; then VC come in (they see significant promise, but company not making money yet) b. The public offering i. First step is issuer needs to get an UW. 1. The UW then signs the letter of intent (in good faith will proceed with the underwriting). 1. If the deal falls through, issuer responsible for expense of managing UW. 2. Counsel for issuer will take lead during the registration statement. 1. Lawyers have to engage in due diligence (testing accuracy of information receive from company ―trust then verify‖ ii. Next file the registration statement. In order for stock to be sold, a registration statement must become effective. (SEC declares this) 1. Once the registration statement is effective, you are under SEC regulations 2. The SEC has to review your registration statement for facial compliance with laws (don‘t really verify the correctness of the registration statement) 1. Looking for obvious inconsistencies and omissions. If find any they will send you a letter, and you file an amendment. 2. Once the company believes that they almost have it right with the amendments, they will issue a preliminary statement. 3. Prior to the effective period, there is a quiet period 1. During this time, the company isn‘t allowed to put out any information. (No interviews, etc.) iii. Typical public offering scenario 1. Typical format of sale is through UWs 1. Company will issue new shares, and sell to UW (often several UW, called a syndicate) a. The UW buy as principles—they will buy the stock and the risk of loss is on them if can‘t sell b. UW in turn will then sell stock to the public (this is the primary market—they are usually selling to pension funds, big institution investors, and the like). Once the primary market sells, it is in the secondary market (NYSE, NASDAQ) 1 c. 2. Don‘t have to use UW but most do b/c UW has client base, connections to get stock sold. iv. Firm Commitment Underwriting (most common way to sell) 1. UW generally has a syndicate (not one UW, bound by the Agreement among UWs (AAU)). 2. There is the managing UW and then the others (syndicate). Managing UW will get the most money b/c he is risking more and does more work getting the company to market. 1. Managing UW usually from large brokerage firm; others UWs from regional offices 2. UWs in syndicate have the AAU; agree to buy certain # shares (obligate self to sell certain # shares to public) 3. No binding agreement between the underwriting syndicate and issuer until day of offering. Prior to this operating, under a letter of intent. 4. Price of stock to public and UW is negotiated, with the issuer wanting a high price and UW wanting a low price (want low price to give to their clients so their clients will want to come back to them) 5. Example: WWE sold 10M shares at $17/share. Price to UWs was $15.81/share (profit 1.19/share). Stock sold to the public for 170,000,000 (issuing company received 158,000,000, profit to UWs 11,900,000) a. The registration statement‘s last amendment is the information above for WWE. This must be disclosed to the public. b. Securities dealers: sometimes they buy from the syndicate to sell to the public. They are not part of the syndicate, but if the syndicate believes they may have trouble selling all of their shares they may get securities dealers to buy. 6. Pricing Example #2: Public offering will be 20. UWs can by for 18. (Other members of the syndicate besides manager UW will pay fee of 20% to the managing UW, in this case .40). If they sell to securities dealer, they may sell for 19. v. GOOGLE and its idiosyncrasies 1. Used the Dutch Auction Format partially 1. Used Dutch Auction to set price for stock a. Dutch auction means people who are qualified buyers bid on price. The highest price at which all can buy the stock is what the price it set at. b. In order to qualify for bid for Google, many firms participating required customer of long standing, and other requirements which made it difficult for ―average individual‖ to bid. 2. Large amount of money (3.99 Billion v. more standard WWE 170M) 3. Number of shares: 29.5 M (later dropped to 20 M) 1. Unique fact is 11.5M were going to be sold by existing shareholders, later this number went down. a. Investment bankers don‘t like existing shareholders selling in IPO b/c looks as though conflict and people want out. Usually have a lockdown for 6 mos. 2. Google had no existing plans for use of proceeds, which is unique b/c usually have plans when go public. vi. Investment Banker: Securities firm who advises and provides financial services for corporations including such services as: 1. UW 2) Finding acquisition partners (act as broker in bringing parties together 3) Securing debt financing (loans-most companies will raise more money through debt financing than equity) 2. Investment banking: retail brokerage operation where sell stock to the public The Dot Com Bubble i. During this time, price for particular commodity bared no relationship to commodity being bought and sold (psychological reasons can explain this discrepancy) 1. For a period of time beginning in the 3rd quarter of 1998 until the crash in May/June 2000, there was a bubble where the price of dotcom stocks beared no relationship to their value ii. Inefficient market: UW pays issuer of stock price decided upon; during dotcom bubble, the price that the stock was trading for was significantly higher than it was in the primary market. 1. This allowed traders to make a lot of money—looked as thought UW underpaid company for stock. Purpose of going public is for company to make profit, but much profit was being made by the traders. 2 iii. Results: over one trillion dollars lost in course of dotcom bubble. The losers were the ultimate buyers, not the initial buyers in the primary market. 1. Many made money as well: shareholders of company may have profited if sold right after lockup period. VCs, UWs, and brokers all profited 2. Dow Jones index rose from 50 to 500 (tenfold increase in value) from 3rd quarter 1998 to January of 2000, but then by the summer it was down to 200 (and is now at 62). iv. Dynamics of pricing under the firm commitment underwriting 1. Stocks were going public without earning a penny 1. Normally, the UW will demand a track of earnings (because stock price in the long run will reflect earnings). However, during this time the investment banking community abandoned its typical practices and procedures, claiming a ―new economy‖ a. The dotcom companies were being evaluated by the hits on their websites, investment bankers believing that hits would translate into profit. The hits, however, did NOT represent value. 2. First Day Pricing during the dotcom 1. There was a mania scenario—everybody wanted to buy the stock. The demand outweighs supply, and the UWs would give biggest allocations to best customers. a. The first day profits were very high—between amt. paid and amt. could sell for v. Legal issues of the allocation 1. First day appreciation of price is common. However, during dotcom appreciation was SO high (abnormal). Question is why did issuers not demand more $ (profits went to public, not to company or UW)? 1. Possible conflict of interest: lower price means UW able to reward good customer and get them to come back. 2. Shareholders (the ones that can‘t sell for 180 days—lockup) don‘t necessary care that the price isn‘t‘ that high because they wasn't to create a ―buzz‖ about the stock (buzz being that the price is going way up) a. This way they can sell at a high price after the 180 days 3. In sum, the UWs want the low price, and the shareholders may have mixed feelings. This may have contributed to the lower prices of stocks and the high appreciation found during the dotcom bubble. 2. The possible legal issue created by this: undisclosed manipulation of the UWs and the first public (favored customers of UWs) 1. Example: Bernard Embers (CEO of WorldCom) received millions of dollars of allocations (IPO offerings) in companies totally unrelated to WorldCom. a. The thought is keeping him happy now will increase getting WorldCom for their next need of an UW. b. In essence, receiving consideration—(promise of future business). If this is not disclosed it is a violation of the securities laws because this is considered to be additional compensation for the stock. 3. Another form of ―fees‖ example of legal issue 1. Example: executive in company who has allocated stock in IPO and his company is in the process of negotiating a loan. The interest on the loan is higher than expected—this is due to the fact that it is additional compensation to the UW. a. Again, not on the surface illegal but you do have to disclose this so the UW because if you don‘t it is a violation of the securities laws. The reasoning behind it is the public has a right to know the relationship between the UW and the issues. 4. Manipulating the market: example of clearly illegal strategy 1. You buy 100,000, but there is a wink and nod that you will buy 10,000 later that day at a higher price. a. This is designed to bump the market price up (create a buzz), which creates a need in people to purchase the stock 5. Ultimately no fraud was found during dotcom bubble. People bought stock in companies even though risks clearly stated. 6. Role of securities analysts during this time was significant, and has led to reform. 3 Lawsuits have been filed by SEC and NY State Attorney General on breach of fiduciary duty. 2. UW (basically investment bankers) were citing their own analysts, and the analysts were getting perks for pushing certain stock. (in theory analyst should be separate from company and maintain analytical v. salesmanship role) vi. Google wanted to avoid the dotcom bubble 1. That is why they chose to go the Dutch auction route—let the public decide what the price should be. 2. It turned out that the strategy did not work, or it appears as though there were problems 1. Founders believed originally the price would be 105-135, but the price it went for was 85 2. It then jumped up to 105 (25% increase in the value of one day) 1. II. Federal Securities Laws and their Philosophies a. The 33 and ’34 Acts both have emphasis on disclosure. i. Basically, philosophy is that informed investor can make informed decision. 1. No review of the merits of stock, no review of economic fairness of offering, no review of inherent value (simply disclose what you know) 2. let the buyer beware, but the let the buyer be informed ii. History behind the ‘33 act 1. Roosevelt believed that the crash of the stock market was the cause of the Great Depression. He believed that 1) manipulation and fraud by securities dealers, as well as 2) lack of reliable market information for investors, causing them to lose faith in the markets were the cause of the stock market crash. b. General approach of the ‘33 and ‘34 Acts i. Full Disclosure: this means everything material about the company (material = everything that person would want to know in making a decision regarding investing in the company) 1. The open disclosure system is different than the state laws that pre empted it—merit regulation (also called ―Blue Sky Laws‖ 1. Merit regulation is norm in most states: state governments evaluate worthiness and fairness of offering, and will allow it to proceed only if they deem it fair to investor 2. California‘s Merit Regulation is found under §25140(b): commissioner may refuse to issue a permit unless he finds that the proposed plan of business and proposed issuance of securities are fair, just, and equitable 3. Blue Sky Laws have been largely marginalized, and most states have exempted securities offerings filed with the SEC. a. If filing on AMEX, NYSE, or NASDAQ exempted from registration under Blue Sky but not antifraud rules 4. SEC is authorized to exempt securities listed on regional stock exchanges or sold to qualified purchaser (sophisticated purchasers) including mutual funds ii. Mandatory disclosure system becomes applicable to the sale and trading of the instrument unless security falls within one of several specified exemption in the federal securities laws) iii. Stiff federal anti-fraud rules apply that are considerably more favorable to the plaintiff than the common law‘s rule on fraud iv. Financial intermediaries who handle transactions in the market for the financial product become subject to close, substantive regulation by the SEC. v. National Market Improvement Act 1. Divided regulation of investment advisers between state and federal regulators, assigning to state regulation those advisers having assets under management of 25 million or less c. Advantages and disadvantages to going public i. Advantages include 1) access to capital 2) once public easier to have subsequent offerings b/c of continuous disclosure system 3) allows insiders to diversify investment portfolio 4) going public can help reputation, can help you acquire other companies 5) retain control and retain money 6) Estate planning (gives diversification of portfolio to help pay off estate tax bill) 7) recruiting new employees (employees like stock options) 4 ii. iii. iv. v. vi. vii. Retain control and money: Often when private company sells significant block of stock, the acquiring shareholder demands representations on the board. In a public company, the ownership is widely dispersed so the people who started the company can stay in control. 1. One way to maintain in control is to reclassify stock. WWE reclassified (McMahon got Class B, which was 10 votes/share. Public got Class A which was 1 vote/share). Disadvantages to being publicly held 1. Have to disclose everything, and it is expensive to maintain periodic filings 2. Sarbanes Oxley Act: increased cost and exposure of doing business as public company 1. CEO must certify correctness of financials 2. independent audit committee Because of transparency, everything you do is relatively quickly conveyed to the shareholders. Your ability to be autonomous is significantly curtailed. Significant negative developments must be reported to shareholders. 1. 8K report issued upon occurrence of materially important events (Enron filed this in October where they had to reduce earnings by 1 billion, and by December they were bankrupt) 2. Private company can keep things under wrap as you try to work things out. Public companies can‘t, as illustrated by Enron Constant Income Expectations 1. Immediate (quarterly) reporting part of the disclosure system. Companies report on an annual basis, and if you misestimate it can drive your stock down. 2. (emphasis on current earnings versus long term value) immediate expense (to go public) 1. WWE offering price was a 170,000,000. Paid 11,900,000 in UW discount and commissions. 3,00,0000 (other expenses). Net to company was 156,100,000. (About 8% cost to go public and raise money). Diversion of time and management committee 1. For smaller companies, the company can be thrown off track in its primary business because everybody is working on the registration statement. 2. Sometimes not worth going public (~under 60 million was marginal utility to company) 1. III. The Regulatory Framework of the 33 and 34 Acts a. Six Statutes administered by SEC (only worry about the first two) i. 33 Act: Governs sale of stock to the public by the issuer and controlling persons 1. When stock is sold by the issuer it must be registered with the SEC prior to sale 1. If sell without registration, civil and criminal penalties 2. NO material omissions (if you do not have complete disclosure or have over misstatements (fraud)) liability under 33 Act ii. 34 Act: Provides for Continuing Disclosure 1. Under the 34 act, you must register stock in 3 different circumstances. 1. Stock is listed on a national or regional stock exchange (NYSE, AMEX). Note NASDAQ is not a stock exchange! 2. If you meet both elements of the following test: a. Securities are held by more than 500 shareholders of record AND 1. shareholder of record = on the ledger b. More than 10 million in assets 2. If you have registered securities for sale under the ‘33 act you have the reporting requirements of the ‘34 act. 1. For example: you go public, but you aren‘t registered on a regional or national exchange (you‘re on the NASDAQ), and you have fewer than 500 shareholders and less than 10 million in assets. a. Under the 34 act you don‘t have to register, BUT since you filed the registration act for sale to go public, you still have to meet the continuing disclosure requirements of the ‘33 act. 2. Many companies will voluntarily register under the ‘34 because NASDAQ requires that companies on it voluntarily register under the ‘34 act. b. Nature of reporting under the ―34 Act 5 c. d. i. File the following forms with the SEC 1. 10K : you file this with the SEC when you send out your annual report to shareholders [since filed with SEC find on EDGAR] 2. 10Q: filed when quarterly statement is sent to shareholders [also found on EDGAR] 3. 8K: when there is an issue upon major events. [SEC filing so find on EDGAR] 4. SEC filing is 10K, 10Q, and 8K. SEC rules i. The SEC rules are presumptively the law (they hold a presumption of correctiveness). Very rarely will someone get a court to say that an SEC regulation is contrary to law. ii. The No Action letter 1. This is not a rule or a regulation. It is a statement by the SEC that if you undertake the transaction you describe in the letter to them, they will not take action against you (meaning they won‘t ask for criminal or civil sanctions against you) 1. This does not mean that they are saying that what you are doing is okay—someone else may sue you under the securities laws but the SEC will not. 2. Only the person to whom the letter was issued can rely upon it, and lawyers look at these very carefully. 2. These aren‘t binding on the SEC, but they will follow them the majority of the time. Adoption of Integrated Disclosure System: Securities Act Release No. 6383 i. Forms S-1, S-2, and S-3 provide basic framework for the registration of securities under the Securities Act. ii. S-1 requires complete disclosure to be set forth in the prospectus, and permits NO incorporation by reference 1. Used by registrants in the Exchange Act reporting system for less than 3 years, and also by registrants who choose to do so or for whom no other form is available iii. S-2 combines reliance on incorporation Exchange Act reports by reference with delivery to investors of streamlined information 1. Used by registrants reporting for at least three years, and allows them to choose to either: 1. Deliver a copy of their annual report to securities holders along with the prospectus describing the offering 2. Or Present registrant contained information comparable to that of the annual report in the prospectus along with description of the offering. 2. In either case, more complete information in 10-K is incorporated by reference into the prospectus iv. S-3 allows maximum use of incorporation by reference of the Exchange Act reports and requires the least disclosure to be presented in the prospectus and then delivered to investors. 1. Generally, S-3 prospectus will present same transaction specific information as will be presented in S-1 or S-2 prospectus. 2. Information concerning the registrant will be incorporated by reference from Exchange Act Reports and the prospectus will not be required to present any information concerning the registrant unless there has been a material change in registrant‘s affairs which has not been reported in exchange act filing of exchange act reports don‘t‘ reflect certain restated financial statements or other financial information. IV. Registration under the ’33 Act a. §5 of the ‘33 Act governs the IPO transaction. There are three periods: pre filing, post filing, and post effective. i. §5, in general states that unless you have an effective registration statement, it is unlawful to offer to sell and sell securities. ii. §4 States that §5 does only applies to: 1. Issues, dealers, and UWs 2. You must be careful though: a whole group can be considered UWs who are not normally identified as UW 1. Can include controlling persons in a company (i.e. in Google, the directors of the company could be included as UWs) 2. Could also include someone who owns a significant portion of stock in a company b. The Pre-filing Period 6 i. The Pre Filing Period starts when the issuer reaches an understanding with the broker-dealer (brokerdealer which is to act as managing UW) prior to the filing of registration statement and the period of 1025-50-90 days prior to when the dealer must deliver the prospectus. 1. Whenever you reach an understanding with the UW the restrictions begin upon that date. ii. Rules 1. Pre filing period states, in §5(c) that it is ―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‖ 1. This makes it unlawful for any person to make use of interstate facilities or the mails to offer to sell or offer to buy any security before a registration statement with respect to the security has been filed with the SEC. a. This means NO OFFERS prior to the SEC filing 2. Limiting language is found in §4(1) which excludes §5 transactions by any person other than an issuer, UW or dealer 2. §5(a) says no sales during this period 1. broad—but §4(1) exempts all but the issuers, UW, and dealer 3. UW: anyone who has purchased from the issuer with a view (intention of) to the distribution (which is a public offering) of a security 4. Broker/Dealer: anyone who in connection with the distribution of the security participates, directly or indirectly in the distribution of the security as a broker (UW can also be broker) iii. Activities in the Pre-Filing Period 1. If as a result of negotiations between issuer and UW they reach a tentative understanding that the UW will sponsor the issue, mutual intention will be embodied in a ―memo of understanding‖ or ―letter of intent‖ 1. this will set forth amount of issue, calls for preparation of registration statement, and formation of UW syndicate a. they will have an ―agreement among underwriters‖ iv. The Price Amendment and Rule 430A 1. 430A permits a registration statement to be declared effective even though it contains a prospectus that omits information on the public offering price, the UW syndicate and certain other information which need not be disclosed in a pre effective preliminary prospectus under 430. 1. This information is now disclosed in a post effective prospectus. v. No offers may be made during the pre-filing period. §2(a)(3): States that the term ―offer to sell‖ 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 1. An offer includes any step in the selling chain 1. Anything which arouses interest in the stock is an offer 2. Anytime you are conditioning the market (conditioning the mind), you have an offer Loeb 2. EXCEPTIONS TO THE DEFINITION OF OFFER 1. §2(a)(3): The offer does not include preliminary negotiations or agreements between issuer or any person controlled by UW who are to be in privity of contract with the issuer a. One cannot start to form a dealer syndicate because they are not UWs. Only when the registration statement is filed, can the dealer syndicate be formed and offers be made Rule 135(a) permits an issuer to publish a notice that it proposes to make a public offering of registered securities if the notice states that the offering will be made only by means of a prospectus and contains only certain additional information 1. title 2. amount 3. basic terms of the securities proposed to be offered 7 Rhoades 3. brief statement of the manner and purpose of the offering without naming the underwriters vi. If the SEC believes that you have made offer during the pre-filing period, they can delay the offering if they so choose. 1. If the conduct is egregious, the SEC can file civil penalties or criminal charges. vii. SEC gave guidelines after Loeb Rhoades on what companies can do during the pre-filing period. SEC Product advertising: can continue to advertise products and services 1. You can advertise your products, but you cannot advertise the company 2. ―Image ads‖ (like Nike‘s where they don‘t necessary advertise specific product). Nike argument: had been doing it prior to pre filing so okay. Probably want no action letter here. 2. Continue to send out customary quarterly, annual, and other periodic statements 3. Continue to publish proxy statements and send out dividend notices 4. Continue to make announcements to press with respect to factual business and financial developments, receipt of contract, opening of plant, settlement of strike, and similar events of interest to the community in which the business operates (This is a form (4)(8)(K)) 5. Answer unsolicited telephone inquires from stockholders, financial analysts, and press, and others concerning factual information 6. Observe ―open door‖ policy in responding to unsolicited inquiring concerning factual matters from securities analysts, financial analysts, security holders, participants in communication field who have legitimate interest in corporation‘s affairs 7. Continue to hold stockholder meetings as scheduled, and to answer shareholder‘s inquiries at stockholder meetings relating to factual matters viii. Broker/Dealer Activities. 1. Broker-dealers are subject to the provisions of 2(a)(10) and 5 by virtue of §4(1) of the act. Guidelines for broker/dealer activities during pre filing period (Rules are only okay for reporting act companies under the ‘34 Act ) 2. Rule 137: This rule relaxes the rules as to the dissemination of information with respect to issuers in registration under certain conditions. If the registrant is required to file reports pursuant to §13 or 15(d) of the ‘34 Act and the dealer doesn‘t propose to be a member of the UW syndicate, the dealer may continue to publish and distribute information, opinions, or recommendations in the regular course of its business. 1. the privilege is destroyed if consideration is received from issuer in connection with the publication or distribution of information 3. Rule 138(b): Further removes the restraints with respect to dealer even if becomes part of 4. Release 5180 1. dealer syndicate) 1. 4. If the registrant meets the requirements permitting the use of forms S2 or F2 and is registering a nonconvertible debt security or a nonconvertible, nonparticipating preferred stock, a participating underwriter or dealer may publish and distribute information, opinions, or recommendations relating solely to common stock or to debt or preferred stock convertible into common stock of the registrant a. If it relates solely to non convertible non participating preferred stock (if it is convertible into common then not okay, participating isn‘t okay either). Communication relates solely to that non convertible non participating stock. If meets these it is okay. Rule 139 (‘34 Act Reporting Company) 1. Where a ‗34 Act reporting company files registration statement relating to its securities, an UW or dealer participating in offering may continue to publish or distribute information, opinions or recommendations w/ respect to registrant or securities during registration process if either: a. Registrant meets registration requirements of Forms S-3 or F-3 (reporting at least 12 months) and minimum float (75 million held by non affiliates—affiliates own large amounts shares or are in control of company) or investment grade securities in the respective form, and such information is contained in publication which is regularly distributed in normal course of business OR 8 1. S-3 means reporting for 12 months, minimum float at least 75 billion b. Such information, opinion, or recommendation is contained in publication which is 1. distributed with reasonable regularity in normal course of business 2. includes similar information with respect to substantial number of companies in registrants industry or contains comprehensive list securities recommended by broker or dealer 3. information isn‘t given more space or prominence c. The Waiting Period (the time between filing registration statement and which it becomes active). i. §5(a) Unless a registration statement is in effect as to a security it shall be unlawful for any person to 1. make use ii. Here, offers are okay, but sales are forbidden. Offers can be made, but are restricted as to form according to §5(b)(1) 1. Offers can be made, but are restricted as to form according to 5(b)(1). §5(b)(1) states that ―it shall be unlawful for any person, directly or indirectly ( Basically under 5(b)(1) a prospectus which (1) to make use of any means or instruments of transportation or communication in interstate commerce 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 §10; or 2. (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 subsection (a) of §10. 2. The prospectus referred to in 5(b)(1) is found in definitional provision §2(a)(10). ―The term 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 1. (a) communication sent or given after effective date of registration statement shall not be deemed a prospectus if it is proved that prior to or at same time which communication a written prospectus meeting requirements of (a) at the time of communication was sent or given to person to whom communication was made and 2. (b) notice, circular, advertisement, letter or communication in respect of security not a prospectus if it state from whom a written prospectus meeting requirements of 10 may be obtained and does no more than identify security, state price thereof, state by whom orders will be executed, and contains such other information as commission deemed necessary or appropriate 3. Basically, the prospectus is a communication by phone, television or radio. 1. Example of unacceptable prospectus during the waiting period: broker sends business card attached to preliminary prospectus. Business card has written note. SEC said card with note is prospectus. It‘s not described in §10, so is violation. iii. An acceptable prospectus during the Waiting Period: 10(b) is the incomplete prospectus (aka preliminary prospectus, red herring). 1. 10(b) states: commissioner shall permit use of prospectus which omits in part or summarizes information in the prospectus specified in subsection a. 2. Securities Rule 430 provides that a form or prospectus filed as a part of the registration statement shall be deemed to meet the requirements of §10 for the purpose of §5(b)(1) prior to the effective date of the registration statement, if it contains substantially the information required to meet the requirements of §10(a), except for the omission of information ―with respect to the offering price, underwriting discounts or commissions, discounts or commissions to dealers, amount of proceeds, conversion rates, call prices, or other matters dependent upon the offering price.: 1. The preliminary prospectus will be identical to the final prospectus except for the pricing and UW information omitted, as well as some changes as to the SEC comments 2. A form of prospectus filed as part of registration statement deemed to meet requirements of §10 of the act for purpose of 5(b)(1) provided such form of prospectus contains substantially the information required by the act and the rules and regulations 9 meets the requirements of §10 may be used to make offers to sell during the waiting period) 1. iv. v. vi. vii. there under to be included in the prospectus, except for omission of information with respect to price, UW discounts, commissions. Summary prospectus: Rule 431 1. Merely a preliminary prospects filed by company that is already reporting under the ‘34 Act FOR AT LEAST THREE YEARS. 1. It basically provides the other information by reference to other documents that they have had to file with the SEC. 2. Rule 431: Summary prospects prepared and filed as part of registration statement in accordance with this section deemed to be prospects permitted under 10(b) of the Act if form used for registration of securities provides for use of summary prospectus and following conditions are met: a. 1(i): Registrant organized under laws of U.S. or any state or territory and has principal business operations in U.S. or territories b. 1(ii): registrants is foreign private issuer eligible to use F-2 c. (2): registrant has class of securities registered pursuant to 12(b) of ‘34 Act or has class of equity securities pursuant to 12(g) or is required to file reports pursuant to §15(d) of the act d. (3) The registrant 1. (i) has been subject to requirement of 12 or 15(d) of ‘34 Act and has filed all material required to be filed pursuant to 13, 14, 15(d) for period of at least 36 calendar months immediately preceding filing of registration statement 2. (ii) has filed in timely manner all reports required to be filed during calendar months and any portion of month e. (4) Neither registrant nor any of its subsidiaries has, since end of last fiscal year i) ailed to pay dividend, or ii) defaulted on installment or indebtedness for borrowed money f. 4(b): Summary prospectus shall contain information specific in situation as to summary prospectus in form used for registration of securities to be offered. g. 4(c): All information included in summary prospectus, other than the statement required by 4(e) may be expressed in condensed or summarized form h. (d) when used prior to effective date, shall be captions preliminary prospectus i. (e) should have statement: copies of a more complete prospectus may be obtained from: 430A permits a registration statement to be declared effective without the inclusion of price-related information. Tombstone Ad 1. This is an offer, but is specifically excluded from being a prospectus in 2(a)(10)(b) and is allowed during the waiting period. 2. 2(a)(10)(b) states that it will not be deemed to be a prospectus if: 1) it states from whom a written prospectus meeting the requirements of §10 may be obtained and, in addition, does no more than 2) identify the security 3) stat the price thereof 4) state by whom orders will be executed and 5) contain such other information as commission deemed necessary or appropriate 3. It is basically a bare bones advertisement that can be used during the waiting period. However it is not usually used until post effective period anymore and is really more of a ―self congratulatory advertisement‖ that is put out by the people who brought the company public. Identifying Statement is also an offer, but not deemed to be a prospectus. 1. Rule 134: Term prospectus doesn‘t include notice, circular, advertisement or letter published or transmitted to any person after registration statement has been filed if it contains only the statement required or permitted to be included therein by the following provisions of this rule: 1. May include any one or more of the following items: a. name of issuer of security b. full title of security and the amount being offered c. brief indication of general type of business, limited to following 1. If manufacturing: general type of manufacturing and principal product or classes of product manufactured 10 in case of public utility company, general type of services rendered and brief indication of area served d. price of security, or method of determination of price, or probable price range e. in case of debt security, interest provision or yield f. name and address of sender of communication and fact he is participating or expects to participate in security g. names of managing underwrite h. approximate date upon which it is anticipated proposed sale to public will commence i. whether in opinion of counsel, security is legal investment for saving banks, fiduciary or insurance companies j. whether in opinion of counsel security is exempt from specified taxes k. whether security being offered through rights issued to security holder, and if so, classes of securities holders of which will be entitled to subscribe, subscription ratio, actual or proposed record date, date upon which rights were issued, actual anticipated date upon which they will expire, an subscription price 2. A communication sent or delivered to any person pursuant to rule which accompanied or preceded by prospect may solicit from recipient indication of interest viii. 135a permits UW or sponsor of investment company securities to engage in generic or institutional advertising of investment company products. Generic advertising must be restricted to explanatory information relating to investment companies generally, different types of funds, products and services offered, and an invitation to inquire for father information. Communication must contain name of broker or dealer or other person sponsoring the communication but may not refer by name to the securities or 2. particular company or to Investment Company itself. 1. 2. 3. ―For purposes of §5 of the Act, an issuer or selling security holder (and person acting on behalf of them) that publishes through any medium notice of proposed offering to be registered under the Act will not be deemed to be offer for sale if: Legend: notice includes statement to effect does not constitute an offer of any securities for sale Limited notice content: Notice otherwise includes no more than the following information 1. (i) Name of issuer 2. (ii) Title, amount, and basic terms of the securities offered 3. (iii) Amount of the offering, if any, to be made by selling security holders 4. (iv) Anticipated timing of the offering 1. (v) Brief statement of manner and purpose of offering, without naming the UW 2. (vi) Whether issuer is directing its offering to only particular class of purchasers 3. (vii) Any statements or legends required by the laws of any state or foreign country or administrative authority and 4. (viii) in the following offerings, notice may contain additional information as follows: a. (A) Rights Offering: in rights offering to existing security holders: 1) class of security holders eligible to subscribe 2) subscription ratio and expected subscription price 3) proposed record date 4) anticipated issuance date of rights 5) subscription period or expiration date of rights offering b. (B) Offering to employees: In offering to employees of the issuer or affiliated company: 1) name of employer 2) class of employees being offered securities 3) offering price and 4) duration of the offering period c. (C) Exchange Offer: in exchange offer: 1) basic terms of exchange offer 2) name of the subject company 3) subject class of securities sought in exchange offer i. Notice can be by issuer, notice to the public ii. Limited notice content: 11 iii. Name of issuer iv. Title amount and amount of securities offered (100 shares of common stock) v. Terms (to be offered in the following anticipated price range) vi. Amount to be made by selling security holders vii. Anticipated time (hope to sell within next 3 mos.) ix. Oral offers are permitted in the waiting period 1. Face to face or telephonic oral communications are permitted in the waiting period. (**but if you are lying then you would be liable for securities fraud). You can call person and they can indicate interest. x. Delivery during the waiting period 1. Rule 15(c)(2)(8) states that in case of seasoned issuer that is reporting company, rule simply requires broker or dealer to respond to written requests for the preliminary prospectus 2. in case of issuer that is not yet filing periodic reports under Securities Exchange Act, 15(c)(2)8(b) requires the broker or dealer to deliver a copy of the prospectus to any person who is expected to receive a confirmation of sale at least 48 hours prior to the sending of such confirmation xi. What is excluded during the waiting period? 1. Any kind of written communication (unless it meets the requirement of §10). These ―other‖ writings are called ―free writings‖. Example: broker can‘t attach memorandum summarizing highlights of deal, can‘t attach letter saying ―if interested, call us.‖ 2. The Google/Playboy Interview: the week before registrations statement filed, Paige and Brin had interview with Playboy editors intended for publication, and it came out during waiting period. 1. This generally wouldn‘t be okay, and may still have lawsuit at later date. 2. Can sue under 12(a)(2): shall be liable subject to (b) to the person purchasing from him a. This is no fault—automatic liability if show violation of §5. Don‘t have to show detrimental reliance or anything else. 3. Note: typically when you sue here it would be UW. But since Dutch auction it would be the company itself. If sue UW they may come back then and sue the issuer. 3. Examples of ―free writings‖ 1. No company advertising, no interview with press if supposed to be published (press considered your agent) xii. Offers may be made during the waiting period, but they are highly restricted. A sale CANNOT be made in accordance with §5(a). 1. Definition of sale: Sale includes executory contract of sale 2(a)(3): Sale includes both executory contracts as well as executed sales. (Executory contract = I will sell stock when registration statement is effective = ILLEGAL). 2. Therefore, the offers you make have to be conditional offers, meaning they cannot be accepted. 1. You can‘t say: ―will you buy 100 shares?‖. You say: ―would you be interested in buying 100 shares when registrations statement effective?‖ they say: ―yes I would be interested in buying‖ a. All you‘ve done then is seeking indications of interest xiii. Roadshows: This is a form of conditioning interest. During the waiting period, and after the preliminary prospectus has been printed, companies go on the road and meet with the underwriting syndicate and substantial investors. These are NOT public meetings and are by invitation only. 1. The preliminary prospectus is distributed, and there is oral presentation regarding the company (oral offers are permitted so this is fine) 2. Written graphs and charts are okay AS LONG AS copies aren‘t given out to the audience. 3. If you invite reporter, you have a ―playboy interview‖ situation and you don‘t want that. You may be okay if didn‘t know they were coming and didn‘t issue their attendance. 4. With the road show, issuer‘s counsel may seek to safeguard forward looking projections and file meaningful cautionary statement with SEC in order to obtain protection of safe harbor here 5. Also issue will present own securities analysts at sessions to present predictions 12 who may sue in law or equity in any court for amount paid plus interest or damages if person no longer owns the security d. xiv. The preliminary prospectus and delivery thereof 1. Preliminary prospectus must meet requirements of §10 and is subject to completion. 1. It may not reflect all comments that SEC has given 2. When you are reasonably certain that have fixed all errors that SEC has found, you will distribute the prospectus 2. The breadth of distribution 1. Rule 430: The preliminary prospectus: if it has substantially the information except for the pricing information, it is okay for the preliminary prospectus. 2. Rule 460: Breadth of dissemination a. In determining whether or not to grant the request for acceleration, the SEC will take into account how broadly the prospectus has been distributed. b)(1): it must be made conveniently available b. Acceleration of reinstatement: Generally, the effective date of registration statement shall be 20 days later. (you file and it will be effective 20 days later, but the 20 days begins with each filing (so filing an amendment starts the 20 days over again) 1. People don‘t want to go public without the SEC review, so they will string the registration statement along until the SEC review. 2. Stringing amendment: registration statements will say that they will amendment until SEC and the issuer come to conclusion that ready to go effective. (also will do if market not right) 3. However, when the market is right you want to go so you will want to ―accelerate the effective date. This is the acceleration. 3. Rule 461: Outlines process for SEC to accelerate a. Request for acceleration of effect date of registration statement shall be made by registrant and managing underwriter of proposed issuer. b. First you have to give written proposal, or if oral you have to give letter indicating that fact 1. If you want it to become effective at a particular hour of the day, the SEC must be advised no later than second business day before day which it is desired that it go effective 2. The following factors will make it difficult for SEC to accelerate with the SEC considers a. No Bona fide effort to make prospectus concise, readable, and in compliance b. Inaccurate prospectus c. SEC investigating d. UW doesn‘t meet financial requirements of SEC e. Transactions that may have affected the market price f. NASD has not issued statement expressing no objections to the compensation of UWs g. If secondary market, you haven‘t taken sufficient steps to ensure compliance 4. Securities Act Release 4968 also states that it will considers the person making an offering of securities if they have taken reasonable steps to furnish preliminary prospectus to shoes persons who may be reasonable expected to purchase securities. Post Filing Period i. 5(a): Unless registration statement in effect shall be unlawful to make sales of securities. 1. §2(a)(3): The term sale or sell shall include every contract of sale or disposition of a security or interest in a security, for value. 2. 5(b)(2): shall be unlawful for any person directly or indirectly to carry or cause to be carried through mails any security for purpose of sale UNLESS ACCOMPANIED BY or preceded by prospectus meeting the requirements of subsection a of §10(a). ii. Note: the 10(b) prospectus can still be used for informational purposes, but the 10(a) prospectus must be accompanied by or preceded by a final prospectus. iii. The Prospectus meeting the requirements of 10(a): 13 iv. v. vi. vii. (2)10(a)(1): definition of final prospectus. The registration statement has parts 1 and 2. You need all of part 1 in the final prospectus. 2. Prior to the delivery of the security, the buyer must receive a prospectus meeting the requirements of 10(a): final prospectus Exception for confirmations: confirmation is a notice (says that they confirm that you bought 100 shares of Google). This is okay, but it does not meet the requirements of 10(a) 1. 2(a)(10)(a)Communication sent or given after effective date of the registration statement is NOT a prospectus if proved that written prospectus meeting the requirements of 10(a) was given. 1. 5(b)(2): if confirmation is preceded or accompanied by a final prospectus, it is not a final prospectus. a. This rule is for all free writings (free writings aren‘t permitted during waiting period—any written offer other than preliminary prospectus) b. Now the broker can prepare summary sheet or letter outlining/highlighting advantage of offering. It just has to be delivered after or with the final prospectus. The types of offers you can have in the post effective period 1. 1) oral offer 2) preliminary prospectus 3) final prospectus 4) free writing proceeded by or accompanied with a final prospectus 5) tombstone ad 6) identifying statement 7) Summary prospects (for companies under the ‘34 Act) 2. Hypo: interview with CNBC morning you go effective 1. not okay b/c doesn‘t meet requirements, doesn‘t meet requirements of §10 2. not all people will have gotten the final prospectus that see the show Rule 434 allows information traditionally required to be included in the final prospectus to be delivered instead to investors in piecemeal fashion. 1. 434 distinguish between issues that qualify to use Form s-3 and those that do not. 1. If you can use S-3, issuer need only deliver normal preliminary prospectus plus ―abbreviated term sheet‘ along with confirmation of sale 2. For issuer not qualified to use S-3 (including IPO) Rule 434 requires issuer to provide a. A prospectus subject to completion (defined by 434(g) to mean with preliminary prospectus or a final prospectus minus the pricing information which 430A permits issuer to omit) and b. Term sheet that sets ―forth all information material to investors with respect to the offering that is not disclosed in the prospectus subject to completion or the confirmation‖ How long must the final prospectus be delivered? Rules §4(3) and 174F (unsold allotment rule). Every purchaser in the initial IPO must receive the final prospectus prior to or at the delivery of stock. The question is must the people who buy from the initial people receive a final prospectus 1. 4(3): Provisions of §5 shall not apply to: transactions by dealer (including UW no longer acting as UW in respect of security involved in such transaction), except 1. A) transactions taking place prior to expiration of 40 days after first date upon which security offered to public [second offering of stock) 2. B) if securities of issuer haven‘t previously been sold pursuant to earlier registration statement instead of 40 days, it goes up to 90 days (IPO) 3. Goes down to 25 days if registered on AMEX, NYSE, NASDAQ (174(d)) 4. 0 days Secondary offering of already public companies: 174(b) 2. As long as the issuer is selling stock, there is no cut off date, meaning they must deliver the prospectus (as long as they are doing the initial issue and are selling the stocks they are authorized to. 1. This is easily achieved in a direct underwriting b/c you issue all stock to the UW, so the issuer is no longer responsible for handing out the prospectus. 3. What about the UW? UW or dealer gets stock from the issuer. The issuer has to give them (the UW) a final prospectus. Rule 174(f) is the unsold allotment rule 1. Obligations of dealer (including UW no longer acting as UW) to deliver prospectus in transactions in a security as to which registration statement has been filed taking place prior to expiration of 40 or 90 day period shall be subject to following provisions: 14 1. e. a. No prospectus need be delivered if the registration statement is on Form F-6 b. No prospectus need be delivered is issuer subject, immediately prior to time of filing to reporting requirement of 13 or 15(d) of the ‘34 Act c. Where registration statement relates to offering to be made from time to time no prospectus need be delivered after expiration 4. Rules regarding dealers: 1. The dealer who effects the transaction from public 1 to public 2: a. If it is an IPO, the applicable period shall be 90 days or shorter period as commission may be determined 1. 90 days: for first 90 days after public offering, if it is an IPO, a final prospectus must be delivered to every member buying for 90 days 2. If IPO and stock is registered on NYSE, NASDAQ, or AMEX (any public exchange) the 90 days is shortened to 25 days (174d) 3. If it is not an IPO, and is a secondary offering the general rule is 40 days. 4. If the company is reporting under the ‘34 Act, and is a public company you don‘t have to deliver a final prospectus for any number of days. The requirement is taken out. 5. 174(b): don‘t need prospectus if issuer subject to reporting requirements of §13 or 15(d) of ‘34 Act viii. One last note: 12(a)(1) allows a rescission of stock sold if you do not file a registration statement. (people can get their money back) Electronic Communications and the ‘33 Act i. Delivery requirements (SEC Release 7233): During waiting period you can make offer by means of delivering preliminary prospectus, and during post filing you have to deliver final prospectus. You have to satisfy the delivery requirements 1. A posting on EDGAR isn‘t delivery (it‘s notice to public at large, not original investors) 2. Two general rules for delivery: 1) Will allow delivery requirements to be satisfied by electronic media and 2) Burden of proof rests on the issuer/UW/dealer was sent to the buyer/investor 1. You have to prove that you sent it. There are four requirements for the general rules. a. Notice: investor needs to be put on notice communicating electronically. 1. Should consider extent to which electronic notice is available and consider supplementing with paper a. If the prospectus is on the website, you need to independently notify investor how to access the prospectus. You can do this by email, letter, and telegram. b. Access: Electronic communication must be accessible to recipient. Question is whether website is easily accessible. 1. Have to give recipient ability to download adobe so they can read it. You cannot send in form that can‘ be accessed on computer. 2. Have to have information in form that can be easily saved and filed. c. Consent: Advance consent to receiving the documents electronically 1. Consent must be expressly received (telephone consent is okay as long as it is authenticated and recorded). Another way would be email. 2. if you want to have all documents delivered electronically, the consent should say this (you can consent to just email or the like as well) 3. Global consent: means that you have consented to all IPO‘s and all paperwork in this way. You can‘t condition a client‘s using you on global consent. d. Record Keeping: must be able to prove that you did in fact transmit the final prospectus (that you did deliver it) 1. Burden of proof is on issuer or UW or dealer to prove that they did deliver the documents. 2. Evidence of procedures evidencing satisfaction of the delivery requirements include: 1) obtaining an informed consent from an investor to receive information through a particular electronic medium couples 15 3. 4. with assuring appropriate notice and access 2) obtaining evidence that investor actually received information (by mail return-receipt or confirmation of accessing, downloading or printing 3) disseminating information through certain fax methods 4) investors‘ accessing document with hyper linking to required document 5) using forms or other material available only by accessing the information Examples of Delivery (for study purposes go through these p. 146) 1. Confirmation with note stating final prospectus available on website, and gives internet web address. Is this delivery? a. No, b/c not all investors can be presumed to have computer or access to WWW. Absent other factors (like consent) this is not enough. 2. Final prospectus on website and dealer confirms by mail to those who have consented to electronic delivery. a. This would satisfy delivery requirements b/c reasonable to presume that those who consented had access to the web. 3. Person consent to email but not website. a. You have to give prospectus to this person then, this is not what they consented to. 4. Investor consents to delivery of all documents electronically, but then finds out two days later that he can‘t get Internet access and revokes consent. Three weeks later receives in mail confirmation of purchase with Internet location of prospectus. a. Since he had already revoked this consent this is insufficient notice Company puts sales literature and prospectus that can be accessed from menu and appear in close proximity to each other. Sales literate proceeded by the prospectus. Sales literature and final f. Hyperlink to research report by registered brokerage firm in the company‘s website. 1. This is not okay, considered to be a free writing. Even if it is preceded by preliminary prospectus, it is not okay because this only matters in post effective and we are in waiting period. 6. Posting on EDGAR is not delivery—not broad delivery for purposes of acceleration of registration statement. It is not meeting the requirement of delivery of prospectus. ii. Hyperlinked Information 1. Most likely you are responsible for this, unless you could not reasonably be aware of it. 2. Information on third party site to which an issuer has established hyperlink may very well meet offer to sale, offer for sale, or offer. 1. Strong inference that hyperlinked information is attribute to issuer for purposes of §5 analysis. Electronic Road Show i. Basics 1. Institutional investors and some ―high rollers‖ (individual show are favored investors of the brokerage house—rich people who spend lots in investing) 2. This is during the waiting period 1. Oral offers are okay during waiting period 2. Purpose is to condition the market 3. Oral offer in the form of a discussion a. Preliminary prospectus is given out, general company information, and then Q and A 3. Strict Script must be followed at BOTH road show and electronic roadshow ii. Road shows: the rules reviewed 1. no free writing permitted 2. traditionally nothing in writing handed out except preliminary prospectus (no charts, no graphs b/c = free writing) 3. do best you can to keep press out 1. they are not invited, if they somehow hear you can‘t impute knowledge to the iii. netroadshow.com 1. basics 16 5. prospectus should appear in close proximity to each other on the menu. duplicates the road show that they give in person, except you watch it on your computer compliments the regular road show: places where the road show will not go, your substantial investors that live there can get benefit of road show (don‘t intend to replace the live road show, but can compliment) 3. allows it to be seen by international audiences who wouldn‘t go to trouble to come for live one 2. No action letter 1. Gives statement of facts: it is only as good as its statement of facts. (If the actual facts turn out to be significantly or materially different, not worth the paper it is printed on). a. Organization of letter 1. Detailed factual background, and then there is a legal analysis 2. Then there is a conclusion, which is really a request that the SEC express itself as saying ―we‘ve read your representations and legal analysis, we will take no action against you if you proceed in accordance with the letter‖ 3. Not even confirming the legitimacy of the legal analysis—the SEC will say that they will not take action b. The person can rely on the letter. The SEC will not revoke retroactively, but will proactively (if you haven‘t done anything, they could revoke it if they wanted to) 1. if they change the regulations in general, then you should check again with them 2. No effect on private litigants: binds only the SEC 3. ―Qualified investors‖ a. Not open to the public, by invitation only to substantial investors. 4. how it works on netroadshow.com a. have to get accesses code, then the qualified investor can look at the program b. They have to agree to: copying downloading or distribution of road show is not permitted, and can‘t copy anything else. 1. This is because anything else would not be part of the written presentation. If you can download the charts, which is handing out a free writing which is prohibited. a. The charts are okay to supplement, and aren‘t a writing if don‘t hand out. b. Google: every picture and all text, there is also a script included in the prospectus. (so you can get around it if put the pictures, charts, graphs in prospectus) iv. Issue: trying to show not same as radio or TV transmission. (These are prohibited). Transmission making offer by TV or radio is prospectus and the only prospectus okay during this period is the one described in 10(b) 1. Under §2(a)(10): any communication written or by TV or radio 1. They get around this in netroadshow: intent is to limit the number of people who can look at it. Statute contemplated broadcast (access to the general public). That is what was understood by drafters when they traveled the statute. Emphasis is on broad. a. This is why invitation to qualified investors. b. 10(f): in any case where prospectus consist of radio or TV broadcast, copies shall be filed with commission 1. conclusion was that broad audience was anticipated and the narrowcasting to controlled audience isn‘t broadcast 1. 2. V. The Registration Process a. Management discussion and Analysis is one of the most looked at aspects (MD&A) 17 b. c. d. e. f. i. Essentially the registrant must disclose and assess future ―trends, demands, commitments or events‖ that hit considers ―reasonably likely‖ to have a material impact on its financial condition or earnings ii. It is a comment on management financial statements from corporations‘ accountants Policy of Disclosure under the ‘33 and ‘34 Acts (Securities Act Release 6383) i. Basically, there is consistent and constant disclosure under both acts. ii. Periodic reports are substantially identical under the ‘33 and ‘34 Acts 1. Example: Rule S-K: standards for filling out the forms goes for both ‘33 and ‘34 Acts 1. Regulation XX: same financial disclosure for accountants under the ‘33 and ‘34 Act iii. Release also announced rationalization of basic forms 1. Stair Step Disclosure (most thorough at first, and then it goes down in amount of disclosure the longer you are reporting) 1. Most comprehensive is Form S-1 (first peek that the public has at a company) 2. S-2 and S-3 have progressively less disclosure a. S-3 is for a larger company b. Both S-2 and S-3 are for companies already reporting under the ‘34 Act. 2. The rationale is that already public, already have been following, don‘t need to know as much ‘33 Act Disclosure Regulation Structure i. §6 and §7, and Schedule A set standards for disclosure for registration statement ii. Regulation C: comprehensive rules for registration statement 1. Rule 430 is contained in here (tells what you need in preliminary prospectus) iii. Regulation S-K iv. Regulation XX (for accountants) Forms in Regulation C: i. S-1 (page 456). 1. Contains Part I and II of the registration statement, and cover page 1. Cover page: follows form on page 456 a. It is fill in the blank basically 2. Part I is the prospectus a. Incorporates rules by reference in S-K 1. 501(a): cover page can only be one page (will allow fold out) a. offering price b. quantity and type of securities offered 2. 501(b)(10) page 349 a. If you use preliminary prospectus: i. Has to say ―subject to completion‖ ii. Filed with SEC 3. Part II is part of registration statement (on EDGAR) but not included in prospectus a. Exhibits and financial statements, referred by reference to 601 of S-K 1. Page 362, tells what must be filed. Different for S2 and S3 2. S1 requires the most. Form S-2 (page 461) i. Looks similar to S1 ii. Eligibility requirements 1. U.S. Company (no foreign) 2. stock is registered under ‘34 Act 3. Has been subject to requirements of ‘34 Act for 36 months (3 years) 1. For three years it has been filing reports—lots of information 4. Not delinquent in its filing 5. Not in default on any required preferred stock payments, or any debts iii. Benefit of Form S-2 1. Incorporation of certain information by reference 1. So much of information required in registration statement may be incorporated by reference a. Other information in documents can be referred to, and makes it part of the statement without having to write it all in. S-3 (page 469) 18 g. i. Eligibility requirements 1. US company 2. Been registered under ‘34 Act for at least 12 months 3. Timely filing (not delinquent in filing) 4. Not delinquent on payments to stock or debt 5. Transactional requirement: aggregate market value of voting and nonvoting held by non affiliates is 75 million or more 1. Thought is: you have substantial public trading of stock and it is more likely in that circumstance that you have coverage of the stock by members of broker/dealer community (public disclosure under ‘34 Act) ii. Item 12: incorporation by reference 1. a lot can be incorporated by reference Management Discussion and Analysis (MD & A) i. Disclosure under the ‘33 and ‘34 Act 1. Old view was forecasts and projections were forbidden 1. Only included factual information b/c opinions could mislead 2. Current view is that forward looking statements are allowed in some situations, even required in others ii. Forward looking statements and forecasts (forecasts and projections) 1. Past earnings are irrelevant: what determines the value of stock is what will happen in the future (price stock discounted value of future earnings) 2. SEC allows ―soft information‖ (soft = projections) iii. Forward looking statements: Rule 175 1. 175(a): ―forward looking statement won‘t be deemed fraudulent statement unless it is shown that statement was made or reaffirmed without reasonable basis, or was disclosed other than in good faith (if unreasonable to say or bad faith, then fraudulent) 1. Fraudulent statement 175(d): material misstatement of fact or omission of material fact 2. 175(a) will apply to, according to 175(b) forward looking statement 3. Forward looking statements are: 175(c) a. Financial projections b. Future operations c. Statement made in Item 303 (Future economic performance contained in M D&A of financial condition and results of operations) 4. Material Fact 405(c): substantial likelihood that reasonable investor would attach importance in determining whether to purchase the security registered (where lawyer‘s judgment comes into play) i. Substantial likelihood: significantly more than 50% 1. Reasonable investor: you don‘t have to anticipate the ―unreasonable investor‖ (person whose decision is not guided by reason) ii. Attach importance in determining whether to purchase security registered (you don‘t have to show that fact is crucial determining factor—meaning it doesn‘t have to be reason why you bought stock—just an important fact) iv. Projection and management plans: 1. Here the projections are encouraged, but not required. 2. As long as the projections are reasonably made in good faith, there is no liability if they turn out v. MD&A: Item 303 (page 295 Code Book) 1. Projections are mandatory in the MD&A. 2. The information discussed in the MD&A: two questions have to be answered with respect to liquidity, capital resources, and results of operations. ( Sarbanes Oxley also requires off-balance to be materially wrong sheet arrangements) 1. You ask two questions for 1) liquidity 2) capital resources and 3)results of operations a. Trends, demands, commitments, events, or uncertainties likely to come to fruition? (1) known and 2) come to fruition) 1. Example: trend is spending cash faster than receiving it. If trend is continues, is it likely there will be a cash crunch in 19 months? 19 2. IF ANSWER YES TO THIS QUESTION GO TO NEXT QUESTION b. If management determines that is reasonably likely to occur, then management must evaluate objectively consequences of known trend, demand, commitment, event, or uncertainty an assumption it will come to fruition. 1. Must disclosure unless the material effect on financial condition or results of operation is not reasonably likely to occur. vi. Item 303 1. (a): Full Fiscal Years: have to discuss registrant‘s financial condition, changes in financial condition and results of operations. 2. (a)(1): Liquidity: identify any known trends, demand, commitments, events, or uncertainties that will result in or that are reasonably likely to result in the registrants‘ liquidity increasing or decreasing in any material way. 1. If material deficiency identified, indicate course of action registrant has taken or proposes to take to remedy deficiency 2. Identify and separately describe internal and external sources of liquidity 3. discuss any material unused sources of liquid assets 3. (a)(2) Capital resources: 1. (i): describe registrants‘ material commitments for capital expenditures as of the end of latest fiscal period, indicate general purpose of commitments and source off funds needed to fulfill commitments 2. (ii) Describe any known material trends, favorable or unfavorable in capital resources. a. Indicate expected material changes in mix and relative costs of resources 4. (a)(3): results of operations 1. (i): describe any unusual or infrequent events or transaction or any significant economic changes that materially affected amount of reported income from continuing operations and indicate extent to which income affected. a. Describe any other significant components of revenue or expenses that, should be described in order to understand registrant‘s results of operations 2. (ii): Describe known trends or uncertainties that have had or registrant expects will have material favorable or unfavorable impact on net sales or revenues or income from continuing operations. a. If know of events that will cause material change in relationship between costs and revenue (known future increase in cost o labors, material, price increases) change in relationship shall be disclosed 3. (iii) to extent financial statement discloses material increase in net sale or revenue, provide discussion to extent to which increase are attributable to increase in prices or increase in volume or amount of goods or services being sold or introduction of new products or services 4. (iv) for 3 most recent fiscal years of registrant, or for those fiscal years in which registrant engaged in business (whichever shortest) discuss impact of inflation and changing prices on nets sale and revenues and income from continuing operations Difference in forward looking statement (optional) and forward looking in MD&A (required) i. SEC Release 6711: MD&A requires disclosure of ―known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrants‘ liquidity increasing or decreasing in any material way‖ 1. Distinction between the two rests with nature of prediction required. 1. Required disclosure is based on currently known trends, events, and uncertainties reasonably expected to have material effects (i.e. reduction in registrant‘s product prices, erosion in market share, changes in insurance coverage, likely non-renewal of material K) 2. Optional forward looking disclosure involving anticipation a future trend or event or anticipating a less predictable impact of known event, trend, or uncertainty. Role of counsel and due diligence i. Issuer counsel takes lead in preparing the statement. Because UW has same liability as issuer does, often UW counsel participates in order to protect their liability. 20 h. i. j. both counsel are responsible for protecting clients, but though the issuer‘s counsel should take lead b/c issuer source of facts and more likely to be familiar with affairs than UW counsel ii. Counsel doesn‘t audit or verify ALL Factual statements 1. Issuers rely upon representations of fact, but their reliance must be reasonable 1. reasonable reliance: you can‘t reasonably rely unless you take some steps to verify correctness 2. Verification of facts is called due diligence 1. if material misstatements, lawyer has committed malpractice and issuer would have to pay fines 2. balance belief and confidence in client with determination to get to bottom of facts, and to determine which can be relied upon 3. If issuer counsel has representation as excellent securities firms, UW counsel will often defer to them (instead of being as involved) iii. With due diligence, we are basically trying to avoid material misstatements or omissions (because the primary anti-fraud remedies relate to and are based on material misstatements and omissions) iv. §11 of the ‘33 Act gives us who can be sued for material misstatements or omissions 1. Liabilities (who can be sued) 1. Issuer has absolute liability (no defenses) for MATERIAL misstatements or omissions 2. All who sign registration statement (all officers and directors) are personally liable a. Means joint and several liability 3. Accountants are liable for financial misstatements 4. Lawyers are liable for material misstatements for expert opinions expressed in registration statement 5. Each UW is severally liable for material misstatements or omissions 2. Defenses §11(b)(3) 1. Every Δ except issuer (who has strict liability) has a significant defense 2. You will be liable if you do not reasonable investigate a. You must exercise due diligence v. The reasoning for lawyers to go to such trouble and pains to verify correctness of statement 1. Issue has absolute liability—you want to protect your client (issuer). You will do your best by doing due diligence. You will have a form diligence letter. Items asked for from the issue on the due diligence letter include: a. 1) minutes from all meetings conducted 2) all reports sent to shareholders 3) stock ledgers 4) stock certificate 5) any voting agreements 6) any material acquisitions vi. Lawyers and Taking stock from clients in lieu of fees 1. Often high tech companies will want you to invest in them (which is stock options) 1. Take the cash price of services and then invest part of it in the company (stock options) 2. If you do this, then you must disclose that there may be a conflict with the shareholder and the lawyer a. For example, bankruptcy 1. as a lawyer you want to try to help keep the company stay afloat 2. as a shareholder you don‘t want the company to go into bankruptcy because the shares will become worthless 3. The ABA allows law firms to do business with the client as long as any potential conflicts are clearly disclosed to the client in advance and are consented to in writing 2. Other companies will not take stock in lieu of fees 1. They think that the issue of allocating stock amongst the partners who worked on the deal and the new partners that didn‘t do anything (did deal 10 years ago and now the company goes public—new people want part of the money) is too difficult 2. Also the conflict of interest The Underwriting Agreement i. First exhibit to the last amendment, document the transaction—price agreement is signed the morning of the public offering ii. Green shoe option: if there are over allotments (more bids for stock than # of share proposed to be sold, company will agree to issue additional shares to the UW_ iii. Representation of Warranty = representation of fact—everything stated is true 21 1. 1. 2. A guaranteed that all is true If UW tagged for liability, may have a K claim against issuer for materially and representation of fact VI. Sarbanes-Oxley Act of 2002 a. Basic Information i. Adopted 7/30/02 1. Some provisions self-executing-went into effect immediately 2. Others were more guidelines for rules that SEC was to implement a. Legislature gave target dates to SEC—common 1/28/03 ii. Primary purposes: 1. Intended to restore investor confidence by improving quality of corporate disclosure and financial reporting 2. Strengthen independence accounting firms 3. increase role and responsibility of corporate officers and directors in financial statements and corporate disclosures b. The transpiration of events that created ―need‖ for reform i. Enron came down, then World Com. The Stock market went down 27% between March and July of 2002. ii. To understand Sarbanes-Oxley helps to understand Enron 1. Enron started out as a gas transmission company, and then Kenneth Ley came on board. He transformed them into an energy giant by adding the commodity trading feature. a. Enron set up trading floor selling futures 2. In general, U.S. companies are short sighted (looking quarter to quarter v. long term earnings) a. Earnings are forecast on a quarterly basis, and if you come in under your earnings forecast your stock price drops 3. In order to help earnings look good for forecast purposes, companies have Special Purpose Entities (SPE). a. It is a form of off balance sheet financing. It also allows businesses to have less debt (less debt means stockholder own more and get better prices for the stock) b. Common to put a building lease on the SPE i. Not treated as debt as it is when you buy building. Accounting doesn‘t treat obligation to pay in the future as debt. (makes leases desirable) ii. Versus when you buy you have debt, and you have depreciation expense each year which also makes balance sheet go down c. Could also have lease for technology, such as computers. i. Here, however, the computers are obsolete in five years you can‘t treat these like a lease—you have to treat like debt. Difference is with land you have substantial value when lease over and here you don‘t. 4. Enron used SPE to help them 1) increase income and 2) avoid debt a. Enron would engage in a transaction with the SPE. They would sell to SPE at a profit subject to debt (for instance, sell something for 500 million subject to the 200 million debts). This means that it is worth 300 million. But Enron was able to increase income by 300 million and reduce debt by 200 million on their balance sheets. b. If an SPE is truly separate, it is okay. The requirements for independence and an SPE are as follows i. New cash of at least 3% from outside investors ii. Operationally independent of the company c. Enron and its SPEs were not really separate. i. It assisted investors in getting the 3% by guaranteeing loans—Enron was ultimately on the hook for the loans ii. Investors and executive officers of the Spa‘s were often Enron employees 1. Operationally you had Enron people running the SPE (at least 5 billion in transactions between SPE and Enron) 2. Over 60 million in compensation was paid from the SPE to Fastow and Koppers (Enron executives) in a four year period iii. They were not separate entities at all 22 c. As a result of the SPE‘s Enron‘s financial couldn‘t be relied on for 3 years and people overpaid immensely for the stock a. Enron started falling through the floor then b/c Enron had secured loans with stock. When the stock price went down, it activated credit triggers (in place so when your stock price went down too much you had to pay the creditor), and their bond rating went down as well b. Results; investors lost a lot, lawyers were tarnished, board was overly trusting and is now getting sued 6. Enron also set up barges says to Merrill Lynch (ML) a. Fastow entered into informal guarantees that within 6 mos. ML could sell barges to Enron SPE at price at least equal to the price they paid—if the price had gone up ML could sell to other company. i. Basically if price went down ML could sell to Enron SPE for same price so no risk of loss on ML, only possible profit if price went up. ii. This gave Enron additional earnings and debt off balance sheet for particular period. b. ML now charged with securities fraud—sham transaction i. True deal would have risk of loss and profits, but not in this situation 7. Now MD&A you have to report SPEs, a great deal of reporting is now necessary Basic goals of the Sarbanes-Oxley Act i. Reform Public Company Accounting 1. Act creates a SRO (self regulatory organization) to regulate audit of public companies, establish accounting standards, and impose discipline on public company auditors. 2. Act also prohibits accounting firm that audits public company from providing any of 10 categories of non-audit services to same company unless services have been approved by Audit Company. 3. Oversight board: Public Company Acctg. Oversight Board (PCAOB) a. Similar to NASD in that it is SRO and funded by dues that have to be paid by firms that audit public companies 4. The directors are appointed by the SEC. There are five members of the PCAOB and serve 5 year terms regulate portion of industry that audits and certifies public a. Only 2/5 have to be CPA b. Chairman may not have practiced CPA for five years prior to appointment 5. Accounting firms that prepare audit reports for public companies must register with the board 6. Auditors must maintain papers for 7 years, provide independent 2nd partner review and approval of audit, and include in audit report a report of auditors‘ testing of company‘s internal control structure 7. Registered firms auditing more than 100 companies must be inspected annually (others every 3 years) ii. Reform governance of public companies 1. Directs SEC to prescribe rules of practice requiring public company legal counsel to report evidence of securities law violations and similar misconduct to company‘s chief legal cou nsel or CEO (if they fail to respond, to the audit committee, directors, or board as a whole) iii. Increase CEO and CFO responsibilities 1. Requires CEO and CFO to certify periodic reports including financial statements filed by company under securities law. It also provides enhanced criminal penalties for knowing false certifications. iv. Improve financial reporting and disclosure 1. Requires public company to make more current disclosure to pubic of material changes in financial condition AND to report all material off-balance sheet transactions or arrangement that might v. Enhance objectivity of securities analysts 1. Requires SEC to devise rules to promote objectivity and independence of securities analysts and protect them from retaliation from employers because of negative reports vi. extending the SOL for securities fraud suits 1. Extends SOL to earlier of 2 years from discover of facts constituting violation or 5 years from the violation 23 5. materially affect company‘s finances d. e. General Coverage of the Act i. Generally amends the ‘34 Act and covers companies that report—file periodic reports under the ‘34 Act. ii. Act‘s requirements are also generally imposed upon companies with filed but not yet effective registration statement under the ‘33 Act 1. Sarbanes-Oxley now applicable to company from moment files its IPO with the SEC a. i.e. Google subject to Sarbanes Oxley 2. It doesn‘t apply to private companies, no company that is not filing periodic reports iii. ONLY DEALS with public companies Reforming Accounting of Public Firms i. Strengthening Auditor Independence: Goal of the act 1. History: Independence required for certification of financial statement (statement prepared in accordance with GAAP). a. 20 years ago had the Big 8 that basically did the audit of public companies. Now down to the Big 4. b. Preparing audit was viewed as a loss leader. They were in the company all the time so they decided to cross sell. The profits of the accounting firms came from non-auditing functions. Consulting is the non auditing services. (For every $1 of audit, received $16 for consulting) i. 1) Sell the tax partners 2) Sell investment consulting advice 3) Sell the IT consulting (set up computer system, financial controls) 4) Appraisal services 5) Executive recruiting 2. Because doing all this consulting the congress though it made them not independent. They want to stay in management‘s good graces, so non audit fees will continue to role in. 3. Sarbanes Oxley says; to preserve independence, you can‘t render other services to those who you audit. a. Services include 1) bookkeeping and other services related to the companies accounting records or financial statements 2) financial information system design and implementation 3) appraisal and valuation services 4) actuarial services 5) internal audit outsourcing services 6) management functions (director, officer, or any decision making function) 7) HR function (management search or reference checks, negotiating compensation or employee benefits) 8) broker-dealer, investment adviser or investment banking services 9) legal or other non-audit expert services 10) any other services prohibited by board Page 5— 4. CPA can render these services, but not to the company that they are auditing. a. Auditor may render the non-audit services only if audit committee of company board approves them in advance (practically they never approve them b/c sets them up for liability if anything goes wrong) 5. Auditors must retain record relevant to the audit or review of financial statement for 7 years after conclusion of the audit or review ii. The Audit Committee 1. Audit Committee rules of Sarbanes Oxley a. Audit Committee: charged with task of interviewing and selecting an accountant. This is no longer an optional feature for public companies listed on a national exchange —now they have to have this. It OPERATES INDEPENDENTLY of the board of directors. (board of directors covers business generally, and the audit committee governs financial reporting matter) 2. The audit committee director must be independent (financially and managerially) a. Can‘t be an affiliate (owning more than 10% of shares of company), can‘t be officer or director, can‘t receive fees other than director fees. 3. If there is not one financial expert on the audit committee board, the company must notify the shareholders a. Financial expert is a CPA or close thereto. He is knowledgeable on GAAP, experienced in preparation of financial statements, experienced in internal accounting controls, and understanding of the proper functioning of the audit committee. 4. Board has power—it alone selects the auditor 24 f. g. Under SEC proxy rules, shareholders approve or disapprove by the audit committee, but the audit committee retains the auditor. b. It has the power to hire independent counsel. c. Audit committee is entity to handle whistleblower complaints, etc. d. company obligated to provide appropriate funding Reforming the role of lawyers of public companies i. Congress wasn‘t happy with role of lawyers in various scandals: 1. Lawyers weren‘t independent enough—accepted representations by officers without investigation (no due diligence). Also didn‘t press negative views beyond the person they were talking to. a. Atty-client relationship: if employee tells you something and you think it‘s a violation of the SEC and you tell other people client won‘t want to talk to you regarding problems. ii. Now Lawyer has duty to affirmatively disclose up the ladder until something is done about it iii. Sarbanes-Oxley Act 307 1. SEC rules apply to lawyers who appear and practice before the SEC a. 1)Transact business or communicate with SEC 2) represent company in SEC proceeding, investigation, or inquiry 3) advise company concerning federal securities laws in connection with document to be filed or submitted to SEC 4) advise company concerning whether particular information is required by securities laws to be included in document to be filed with or submitted to SEC 2. Sanctions: barred with respect to SEC 3. Implement up the ladder reporting scheme. If you in representing client believe that there is a material violation of the securities laws or a breach of fiduciary duty, then you must report up the ladder. a. Report to chief legal officer or equivalent [can go jointly to CLO and CEO] (not sufficient to say to client violations of security law). i. If not appropriate response to you from chief legal officer (appropriate response = give reasons why no problem and think they are correct or give steps taking to correct problem) ii. no appropriate response: then you have to take it to the next level to an independent committee of the board (like audit committee) or board of directors itself b. Originally Sarbanes-Oxley said that if they did not do anything when you reported up the ladder you had to have a ―noisy withdrawal.‖ The lawyers protested this immensely. i. The noisy withdrawal said that they had to resign from the account and notify the SEC ii. If you went to the SEC and it turned out there was no violation, then the attorney would be guilty of breaching the attorney client relationship iii. Attorneys were in arrears regarding this provision and it was taken out of the act until it could be further reviewed (still no word on it to this day) 4. Handout: Are you a potential reporting/practicing attorney? a. Look at this on your paper CEO and CFO certification of financial results i. Both the CEO and the CFO have to certify that financial results fairly represent the companies position 1. This applies to public companies so on 1) annual 10K report 2) 10Q report the CEO and CFO certify that these fairly represent present financial situation a. Act Section 302: CEO and CFO certify that 1) he/she has reviewed report 2) report contains no material misstatement or omission 3) based on his/her knowledge, financial statement s and other financial information in report ―fairly present‖ in all material respect company‘s financial condition, results of operation, and cash flow 4) certifying officers are responsibly for establishing and maintaining disclosure controls and procedures 5) certifying officers have designed theses controls and procedures to ensure that material information is made known to them by others in company 6) certifying officers have disclosed to company‘s auditors and to audit committee of board of directors any significant deficiencies in design and operation of internal financial controls 7) certifying officers have indicate in report whether there ere very significant changes in internal controls 25 a. h. Fair representation is important because broader than GAAP. When accountant does it, says done in accordance with GAAP. Fair presentation goes beyond—it is a broader term because congress says that wrong statements were in accordance with GAAP. Significant for CEO because means that they can‘t rely on accountants in making the certification—must go beyond this. ii. CEO also have to certify management has put into place adequate for internal controls 1. You have to put in place the adequate internal controls to make sure internal audit is correct and accurate. CEO says that in best efforts tried to make sure internal controls. a. This is a huge expense item—accounting fees and audit fees have doubled. Professional consultation to help CEO and CFO make representations—very expensive. ii. This section has not been disputed among business individuals: Business roundtable noted that senior management expected to know how the company earns income (business said it was fine—they should know this information) and risks that are in business. 1. As a CEO have to know how company earns income. 2. Two criminal provisions a. 906 is criminal statute. i. Requires that periodic reports filed by company under ‘24 act be accompanied by written statement in which CEO and CFO certify that report, including financial statement, fully comply with reporting requirements of ‘34 act and that information fairly present financial conditions. ii. Two levels of penalties: 1. if officers certifies statement ―knowing‖ that periodic report don‘t‘ meet ‘34 act or doesn‘t ―fairly present‖ financial situation, maximum criminal penalties are fine or 1 million or imprisonment for 10 years or both a. knowing = knew info false but didn‘t know violation of Sarbanes-Oxley Act 2. If willfully certifies the statement knowing that periodic report doesn‘t meet standard, fine can be up to 5 million or 20 years in prison or both a. Willfully = knew false and knew violation of Sarbanes-Oxley Evaluation of Sarbanes-Oxley i. Overall goal of federal securities laws is to get people to invest. They do this by full disclosure and no fraud as their guidelines 1. However Sarbanes-Oxley may affect companies going public and thus people can‘t invest as much. Companies don‘t want to go public because of the criminal penalties and full disclosure. a. A lot of foreign companies having shares on U.S. exchanges are withdrawing. There is now coming into effect foreign companies having shares listed on U.S. exchanges will be subject to Sarbanes-Oxley. b. BMW has de-listed. c. Now many foreign companies in process of de-listing. The trend is picking up. i. However to de-list they need to have less than 300K shares held by U.S. investors, which can be hard to prove iii. Effectiveness of new criminal penalties: 1. Financial crimes—the crook makes a cost benefit analysis. Most of the time they willfully take the step and don‘t believe they will be caught. 2. Question is whether they will be effective iv. Failure to understand the significant cost 1. Dollar outcome—it is doubling compliance costs. Some people are questioning whether public is getting that much additional benefit. 2. Also loss of person power v. Changing corporate culture 1. For a capitalistic system, there must be ―animal instincts‖. People who will be aggressive 26 i. VII. Definition of a Security a. §2(a)(1) of the ‘33 Act (and §3(a)(10) of the ‘34 Act) give the definition of a security i. ―Term security means any not, stock, bond, debenture, evidence of indebtedness…‖ 1. The definition uses the words “unless the context otherwise requires” which means we have to look at the facts—look at the economic transaction in light of the securities laws b. The investment contract: applies to all non standard forms ( Landreth Case makes this point—the investment K expands to fit all arrangements. It encompasses the thoroughly legitimate (marketing level schemes) to fraud (Ponzi Schemes). If you are an investment contract, then you are a security. i. Howey case tells us what an investment contract is. Facts: tourists come down to FL and are offered a land sale contract and service contract for orange groves. There are two parts: 1) land sale K = title to land, and 2) service contract = harvest and plow for you. Upon harvest time, all fruit is pooled together and the proceeds are allocated based upon the relative ownership. 1. Requirements of an investment contract. An investment contract is a contract or scheme for the purpose of placing capital in a way intended to secure income or profit from its employment. 1. Person invests money 2. In a common enterprise 3. With the expectation of profits 4. Predominately from the efforts of others 2. Howey and the Elements 1. Howey is clearly a common enterprise because there is a pooling of resources. They pool expenses for farming AND pool the proceeds of the fruit. 2. Expectation of profits (this is why people did it) 3. Solely through the efforts of promoter or 3rd party a. Don‘t participate in the management of the deal. The word solely has been defined much more broadly. It is now substantially. ii. Life Partners Case tells us that for the prong of solely for the efforts of others, we are looking for important actions on the part of the promoter for making money, not merely ministerial duties. 1. Facts: Viatical settlement in which the investors are buying out life contracts. The promoter was setting up deal and price between the owner of the insurance policy and the investor wanting to buy the viatical settlement. 2. Case changes solely by the efforts of others to predominantly by the efforts of others. 1. Efforts by promoter in this case were ministerial. Although they were important, no skill was needed to do them. 3. We only look at post purchase activities, and not pre purchase activities for determining the prong of solely by the efforts of others. Note: District Courts will allow pre-purchase activities as well, but not SEC. 1. In Life Partners, the only activity after the sale by promoters was managing the policy and filing death notice. They did nothing to make the money. You were waiting for someone to die. 4. The investor‘s profits depend predominately upon promoter effort, then we would find it to be a security. But if the value of the promoter‘s efforts are already impounded into promoter fees or the purchase price of the investment, and if neither the promoter nor anyone else is expected to make further efforts, the need for federal securities regulation is diminished (less likely to be security) 5. No cause of action until there is common enterprise is formed iii. Common enterprise factor: commonality 1. Vertical Commonality 1. Broad view (means more classified as security): investor AND promoter must have economic relationship AND the fortunes of investor are linked to efforts of promoters. a. NO linkage between whether promoter makes money and whether investor makes money. The promoter is paid whether or not the investor makes money. Therefore if promoter makes money from salary or commission, you have broad commonality. b. Means you need only one investor to have vertical commonality. c. 9th Circuit is broad vertical 27 iv. v. vi. vii. Strict/Narrow Commonality (least likely to be found to be a security): Fortunes of investors linked to fortunes of promoters. a. Promoter doesn‘t make money unless investor makes money. 2. Horizontal Commonality 1. Pooling of investors is required, and you must have commonality of investors (have to have agreement with promoter together). Life Partners is an example of this. a. Need the investor to investor link—at least two investors and a pooling of funds and a sharing of profits. Solely from the Efforts of others has change to ―predominately from the efforts of others‖ 1. Miller v. Central Chinchilla Group: courts changed definition in that promoter representation needed only minimal care (promoter creating secondary mkt. for the good) 2. If services by the investor were trivial in comparison to value of services rendered by promoter, would likely meet test 1. if promoters services essential for profit making potential even if investor contributes some services that are minimal would pass 2. Ac courts transitioned from economic impact of investor, these are not taken into account and services viewed as predominantly rendered by promoter SEC v. Koskot pushes solely by the efforts of others. 1. Facts: multi-level marketing scheme which was to sell beauty products—pyramid scheme (pyramid scheme exists when profits dependent upon signing up new investors and no realistic probability that there will be enough consumers for profit) 1. Promoter was Koskot, Distributor got 3K for signing people up, and Supervisor got 400 for signing up people. 2. Issue is whether ―solely from efforts of others‖ 1. Clearly services by the investors; got people to go to the meeting. Koskot says that they do not require that the promoter be the sole person to render efforts, but the promoter efforts must be the undeniably significant ones in revenue generation. 3. Standard under Koskot 1. ―Whether the efforts made by those other than the investor are undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise 2. Franchises are different b/c franchisee has control. 4. Koskot is example of broad vertical commonality. SEC v. Edwards Whether you have fixed or variable ROR it can be invest. K 1. Facts: Δ sold phones, management agreement, leaseback agreement and buyback agreement. Said they would get 14% ROR. 1. Leaseback = Δ owns phones as lessee, Π buys agreement and leases back to Δ. 2. Didn‘t make enough money to pay lease payments (had to get more money from getting more investors into the situation—Ponzi Scheme) 2. This is security going off the Howey Test 1. Investment of legal consideration: money 2. Expectation of Profits: did it for 14% ROR 3. Commonality a. Horizontal commonality: there was sharing of the profits from all pay phones arrangements—didn‘t just get profits from your own. 4. Substantially from efforts of others a. Π is passive, didn‘t maintain phones or anything. 3. Very similar to a debt instrument: investor never takes possession of property or anything. Investor doesn‘t have benefit to appreciate value or bear risk of depreciation (very similar to SPEs) The mere use of the words ―stock‖ will not make the offering a security United Housing Foundation 1. Facts: Building a housing co-op and in order to get room you have to buy share of stock, which entitles you to occupy the apartment. The price of apartment rent went way up and people said security fraud. The stock ownership couldn‘t be transferred, encumbered, and you had to sell back to company without profit. 28 2. 2. 3. The stock is not a security. Although the definitional provision of §2(a)(10) says stock is a security, preface to 2(a) invites a contextual analysis—if context indicates otherwise you can narrow the terms. (Nomenclature used in statute is not determinative, context influences how the term is interpreted). In this case, not like normal stock. Voting rights were different, no profit intent. Tenants viewed it as downpayment on housing. 1. 4. What distinguishes a security transaction is investment where one parts with money in hope of receiving profits from efforts of others and not where he purchases commodity for personal consumption. Stock for purposes of 2(a)(1): There may be occasion when use the traditional name of stock or c. viii. Interest in Condominiums can be a security: SEC Release 5347 1. Offering of condo united in conjunction with any one of the following cause offering to be security 1. Condo with rental arrangement or other similar service, offered and sold with emphasis on economic benefits to purchaser to be derived from managerial effort of promoter 2. Offering of participation in rental pool agreement 3. Offering of rental or similar arrangement whereby purchase must hold his unit available for rental for any part of year, must use exclusive rental agent or its otherwise materially restricted in his occupancy or rental of his unit. General Partnerships are presumed not to be a security Williamson v. Tucker i. Difficult to overcome the solely by the efforts of others portion of the test. ii. A general partner has the power to bind the partnership (even if among partners have agreement that only one will make decisions), but as to 3rd parties without notice, those partners have power b/c of joint agency. Even if the individual is not active; if he has the right to be it will destroy solely by the efforts of others. iii. EXCEPTIONS to the general rule 1. An agreement among the parties leaves so little power in the hands of the partner or venture that the arrangement in fact distributes power as would a limited partnership. Need clear intent 2. bonds would lead purchaser to justifiably assumed federal securities laws apply. Clearly would be case when underlying transaction embodies significant characteristic typically associated with named instrument. general partners passive. Partner or venture is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership or venture powers. Example, senior citizen is d. Partner or venture is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he can‘t replace the manager of the enterprise or otherwise exercise meaningful partnership powers Limited partnerships: the general presumption/rule is that a limited partnership is a security because all four elements of the Howey test are met. The 3rd party is general partner, and limited partners are the investors. If the limited partner constitutes control of the business, he will be liable as a general partner . There are two acts that govern what a limited partner can do. i. Uniform Partnership Act (used in some states). The limited partner can 1) inspect the books 2) force general partner to do detailed accounting 3) share of profits 4) if fraud on the part of the general partner, can ask court to liquidate business & distribute assets ii. Revised Uniform Partnership Act (used by CA): Limited partner deemed to not participate in control of business solely by doing one or more of the following: 1) power to remove general partner 2) enforce expansion of partnership 3) consulting and advising general partner 4) veto power iii. Steinhardt Case overcame the general presumption and found the deal to NOT be a security. 1. Facts: Investment in underperforming mortgage loans (REOs). Citibank formed partnership who bought the REOs. Steinhardt was a limited partner in the partnership and was a sophisticated partner. 1. Steinhardt had powers: 1) power to approve investment 2) power to veto etc. 2. Because of the control Steinhardt exerted over the deal, and the fact that he was a sophisticated investor, this was found to be a security. 29 3. general partner & inexperienced. e. f. Note that if he had not been a sophisticated investor, the result likely would have been different b/c he could not have exercised his control. 4. If there were more than one investor, the court would look at the group as a whole and decide whether or not they had control. Look at the rights retained by the investors as a group and decide whether or not they meet the solely by the efforts of others test. Non corporate entity forms: Limited Liability companies have no statutory presumption on whether or no they are a security. i. Here, we cannot use a ―stock‖ test b/c stock is only for incorporated entities. Therefore, once again we will use the investment contract test. ii. There is no general rule for the LLC. The LLC is flexible, 1. because it can be member managed (where all individuals who have ownership rights manage the company) 1. In this case, the presumption is that it is NOT an investment contract 2. It can also be extremely centralized—there is one person who is in the middle who manages. 1. This is probably going to be an investment contract. iii. Monsanto Case: Monsanto and STI formed an LLC. Monsanto and STI both sold their LLC interest to the plaintiff Great Lakes. (you now have a single member LLC) 1. The court held that this is not stock because stock (in its traditional sense) is from an incorporated company. An LLC is not incorporated. 2. Since it is not stock, the court questioned whether or not it was an investment K. 3. Element 1: Solely from the efforts of 3rd parties: in this case the plaintiff bought the LLC with management in place, and gave managers the sole right to manage the LLC. However, the plaintiff had the power to remove the manager at anytime, with or without cause. There is coercive power, which is enough to destroy the solely from the efforts of others . 1. If the member has power to control the actions of the manager, and the means of controlling the source of power, then the LLC will NOT be an investment contract. 4. Element 2: Commonality 1. Court didn‘t believe there was commonality b/c there was only one investor. 2. No horizontal commonality b/c there is only one investor. 3. No broad vertical commonality: no promoter whose efforts are tied to the fortunes of the plaintiffs 4. no Strict vertical commonality: no fortunes of the promoter tied to the promotions of the investor The purchase of stock, in its traditional sense, will be a security Landreth i. Landreth involves the offer and sale of corporate stock (the first case we did involving corporate stock was the Foreman case of co-op stock). 1. Foreman stated that stock is not stock if it merely a form of real estate, which it was in that transaction. ii. Facts of Landreth: Landreth is going to sell a timber company. There was a broad offering of the stock. Prior to the broad offering, Landreth Timber Company is damaged by fire. In the broad offering they stated that it would be fixed up prior to the sale. Dennis bought 100% of the stock of Landreth Timber Company. 1. Dennis brings in Bolten as a co-investor. They create a corporation called B & D. Dennis and Bolten own 85% of the stock, and bring in 6 more investors who own Class B stock (15%). B & D owns Landreth Timber Company. It is one tier removed from the shareholders. 2. Then B & D merged into Landreth Timber Company. B & D is the surviving corporation, but they change the name to Landreth Timber Corporation. 1. In a merger, you have an agreement that the merged corporation disappears and the surviving corporation succeeds to all assets of the merged corporation. iii. The plaintiffs allege 10(b)(5) violation of the ‘34 Act (material omission of statement of fact, which is securities fraud). For this they may receive damages. iv. They also seek rescission under the ‘33 Act: Under 12(a)(1) you may seek rescission of the stock b/c it 3. v. The lower court said this was not a security under the Howey Case as well as the form of the transaction: it was really buying real estate. They used the sale of business doctrine: which states that you use an was a public offering and no registration statement was filed with the SEC, no registration statement had gone effective prior to the offering of the stock 30 g. economic analysis if buying stock—if you sell the entire business, and the form of transaction is stock, it should be viewed as a sale of assets. vi. Supreme Court overturned the sale of business doctrine. 1. Now we ask whether or not it is stock, and if it is stock it is a security. 2. The type of stock that is always a security is ―traditional stock‖. The five characteristic of this stock include 1. right to receive dividends contingent upon an apportionment of profits 2. negotiability (you can sell it) 3. ability to be pledged or hypothecated (you can borrow on it and pledge it as collateral) 4. Conferring of voting rights in proportion to the # of shares owned 5. Capacity to appreciate in value 3. Note that although this is traditionally what stock is, preferred stock doesn‘t necessarily have all of these associated with it, but it is still a security. 4. The investment contract analysis does NOT apply to traditional stock 5. The corporation here could have just sold assets subject to liabilities and this would have been a real estate transaction, or assets subject only to the liabilities that you agree to accept, and either would not be associated with the securities laws. With notes, we have to use the Family Resemblance Test in order to decipher whether or not the note is a security. Reeves v. Ernst & Young i. Facts of Reeves: There is an agricultural co-op that sells demand notes. The co-op goes bankrupt and the plaintiffs (who had bought the demand note) sue Ernst & Young b/c said Ernst & Young didn‘t follow GAAP. ii. This is a suit under 10(b)(5) of the ’34 Act (which is virtually identical to §17 under the ‘33 Act. 1. §17 under ‘33 Act: Fraudulent transactions 2. 3(a)(10) of the ‘34 Act: specifically says ST notes are not going to be a security (which means less than 9 months) iii. 3 approaches to determining whether a note is a security 1. Investment v. Commercial (6th and 10th circuits) 1. Investment notes will be securities, while commercial notes are NOT securities. 2. Commercial = note to evidence purchase price of property with interest added in to compensate for the time value of money. Generally it does not include LT investment of business or enterprise of issuer or note. a. For example, bank gives loan for ST period. They aren‘t relying upon success or failure of business—believe can get money out prior to this happening or they are relying upon the character of the borrower. 2. Howey 4 factor test 1. Court rejects this test because: demand notes may not fall under the test but they are securities. Courts don‘t want to use the investment test because congress did not intend this—stock and notes are separate from investment contracts. 3. 2nd Circuit Family Resemblance test 1. The types of notes listed are in the ―family.‖ What you need to do to prove that something is NOT a security is to show that they fit within this category by either being the same as something listed, or being similar enough to them. a. Note delivered in consumer financing, note secured by mortgage on home, ST note secured by lien on small business or some of its assets, note evidence a ‗character‘ loan to a bank customer, ST notes secured by an assignment of accounts receivable, or not which simply formalizes open account debt incurred in the ordinary course of business [the last one is like having a ―tab‖] 2. Approach to the family resemblance test a. You begin with the presumption that a note is a security (meaning that the burden of proof is on the person seeking to have the note removed from the definitional provision of security). 1. Obviously this is a rebuttable presumption, which is rebutted by showing a strong resemblance to one of the enumerated categories of the instrument. 31 b. You will rebut by showing that the note fits within one of the enumerated categories in the family, or if it does not fit within one of the categories, that it closely resembles one or more of the members of the family. c. In order to show that it fits within category, or closely resembles use the following 4 factors. This is a weighting analysis and you DO NOT have to satisfy all of these factors 1. motivation: both of issuer and buyer—is the issuer buying the note to raise money for business (looks like security), is buyer buying for income (looks like security) 2. Plan of distribution: is there going to be common trading or speculation for the investment? a. If you can show any kind of secondary trading, good indication that this is investment rather than commercial note. 3. Reasonable expectations of the investing public: does the investing public view these as investments, and would they have the reasonable expectation that someone is looking out for them if there is fraud? 4. Any other regulatory scheme: court looking for regulatory scheme that covers the note iv. For the Ernst & Young Case: applying the factors 1. Motivation of parties: 1. co op issued in order to raise capital 2. buyer bought for investment, attracted by the interest rate 2. Plan of distribution 1. notes were offered to members and nonmembers, found to be in the broad segment of the public 3. reasonable perceptions of the investing public: reasonably expect it to be a security 1. it was called an investment, called a security, no risk reducing factors about it 4. Other regulatory scheme: none found here v. Therefore this demand note was a security VIII. Exemptions From Registration a. Introductory Information i. §5 by its terms will apply to all sales and offerings of securities. Because it would not be feasible for the SEC to regulate every single offering, there are exemptions. The following three are the ones that we will focus on. Note: you are still liable for fraud here, you just don‘t have to register under §5. 1. 3(a)(9): Any security exchanged by the issue with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly 1. For example, there is a CA corporation turning into a DE corporation. You would have to exchange the securities—this is exempt from registration under the ‘33 Act. 2. 3(a)(10): Securities which is issued by court approval is exempt 3. 3(a)(11): intrastate offering exemption 1. if it is within the state where the issuer is a resident, or if it is a corporation they are located there and do their business there, it will be exempt ii. §4 also contain exempted transactions. iii. In both of these, you are still liable under §15 of the ‘33 Act, which is the antifraud provision iv. These are primarily allowed as offering of securities without filing a registration statement, but we are still concerned about securities fraud so you are liable under §17 if it is a security v. §3(b) States that the SEC, by regulation and rule, may expand the list of exempted securities as long as the total amount raised in the offering does not exceed 5M. 1. Also, Rules 504 and 505 give exemptions created by the SEC under its rule making authority vi. §28: States that the commission, by rule or regulation, may conditionally or unconditionally exempt any person, security or transaction or any class or classes of persons, securities, or transaction from any provision or provision of this title or of any rule or regulation issued to extent that such exemption is necessary or appropriate in the public interest and is consistent with the protection of investors vii. §4 Exemptions 32 b. 4(2) transactions by issuer 1. this only covers the issuer transactions, meaning securities issued by the corporation, NOT INVOLVING A PUBLIC OFFERING 2. 4(3) Transaction by a dealer (after market transactions by a deader) 1. Deals with the final prospectus having to be delivered—it must be delivered by the dealer for 25 days following the date of the IPO 2. Dealers are not exempt from §5 and will have to deliver this. IF it is outside the time limits then they do not have to. 3. 4(2) Private Placements or public offering 1. There is no definition of a private offering 2. Rule 506 or Regulation D (p. 186): 506 don‘t define a private placement or an offering, but it does provide a safe harbor, and provides objective tests. If you meet them you are deemed to have a private placement. a. 506 does not Ralston Purina Case i. Facts: made offerings of share of their stock to ―key employees‖ that asked about it. 1. The key employees were leaders, people up for promoter etc. This was a large group of individuals. 2. No active solicitation by Purina—employees did have to ask for it. ii. This was deemed to be a public offering. The court refused to base the determination on whether or not it was a public offering based on the number of offeree (no quantitative test). 1. You can have a private placement with 1M offerees as long as they qualify under the objective test of Rule 506, it is a private placement. iii. The Court based its decision on the purpose of the ‘33 Act 1. The purpose of the ‘33 Act is to get information to the investors that would need it. 2. Need requirement: if it is a transaction where there is no practical need for the registration, or where the public‘s benefits are too remote then we will not require the registration 1. The statue is to protect investors for informed decisions. Since it is exempt to those to which there is no need, whether or not it is a private placement should turn on whether the person needs the act. 2. if every offeree can fend for himself by the virtue of the information, then it is a private placemen, but if an offeree cannot fend for himself because he does not have the information he needs then it is a public offering 3. The need requirement can be met by (1 of the 2) 1. access to information (such as your position at the company), but here we would want to know that they understand the information on some level a. So a file clerk would have access to information but would not understand it, so she would not meet the access requirement. 2. Disclosure a. Such as a registration statement iv. The case went on to suggest that if the individuals in this case had been given the information in a disclosure, and it contained the same information as a registration would, that it still could be a private offering v. Burden of proof is on the individual saying that it IS a PRIVATE PLACEMENT 1. c. Doran v. Petroleum Management Corp. i. Facts: Dealer was selling interest in a limited partnership. PMC was the general partner and the individuals who would be investing would be limited partners. 1. Two classes of partnership interest—participant or special participant 1. The special participants would be paying the intangible costs such as arranging financing, etc. These were tax favored at the time and could be deducted immediately which appealed to Doran. 2. There were up to eight offeree 33 d. Doran became a special partner, investing 25K cash and assuming the responsibility to pay for a 100K note. The company went broke and he doesn‘t want to pay the note back—wants rescission of his investment. 4. Lower Court held that it was private placement b/c Doran was sophisticated. ii. Appellate court said we look at ALL offeree, whether or not they bought, to see if they are ALL sophisticated to determine whether it is a private placement or not 1. The case was remanded on this issue. 2. If one person out of a group of eight is not sophisticated, and it is a public offering and ANY one of the offerees can sue on this, even if he or she is a sophisticated investor. iii. The case gave a 4 factor test to determine whether there should be an offering exemption 1. The number of offerees and their relationship to each other and the issuer 1. Professor thinks that this is the most important and the others on some level subsume to it. 2. The relationship to issuer reveals the characteristics and knowledge of offerees. (This is not if they are related and the like). It is a relationship of knowledge, and we are trying to determine whether they are in a position to know what they need to know about the company. It‘s a relationship of information. We want to make sure they have the information. a. How do they achieve the knowledge? Could have given a registration stmt. type document containing that information. They could have given access to information. (private placement memorandum, ppm) 2. Number of units offered 3. Size of the offering 4. manner of the offering iv. On remand the court said that Δ must demonstrate that ALL offerees, whatever expertise, had available information that would be afforded through a public offering 1. The knowledge can be gained through overt disclosure or through access 2. The court also refers to Rule 146 (now 506) which provides objective tests to determine whether or not it is a private offering Regulation D: Safe Harbor Rules are contained in here i. Ralston and Doran cases are important, but for planning purposes you want to use one of the safe harbor rules knowing you are in good shape if you meet the test 1. There are times that you can have a situation where you don‘t meet them, but does meet Doran and it will be okay too. But these situations are rarer. ii. Approach 1. 3(b) is the provision where the SEC has the power to exempt securities not involving more than 5M of size. The SEC has utilized this in part of Regulation D (only reference to §3(b)) you need). 2. Regulation A can also be helpful but it is limited to 500K and we will not worry about it for class purposes. iii. Regulation D has 3 provisions 1. 504: limits size of offer to 1M 2. 505: limits size of offer to 5M 3. 506: no limit on size of offer iv. Format of Regulation D (p. 177) 1. The operative rules are the exemptions contained in 504, 505, and 506. The rest of the information in Regulation D supports them. 2. 501 is definitional provision 3. 502 is general conditions precedent that must be satisfied prior to taking advantage of rules 4. filing requirement: must give notice 3. IX. Regulation D: only the issuer can rely upon this, not existing shareholders a. Notes i. Note 1 34 1. b. ii. Note 2 1. You are still liable under any applicable state law regulations relating to the offering iii. Note 3 1. If you are unable to meet Regulation D that doesn‘t give rise to a presumption that you can‘t get exemption under §4(2). iv. Note 4 1. Rules available only to issuer of securities and not to affiliate of issuer or any other person for resale of issuer‘s securities. The exemption is only for the transaction sin which the securities are offered or sold by the issuer, not for the securities themselves. v. Note 5 1. May be used for business combinations that involve sales by virtue of 145(a) or otherwise vi. Note 6 1. Regulation D isn‘t available for an issuer for any transaction that is in compliance with the rules, but is part of a plan to evade registration provisions vii. Note 7 1. Securities offered and sold outside the U.S. in accordance with Regulation S don‘t have to be registered under the Act. Regulation S can be relied upon even if coincident offers and sales are made in accordance with Regulation D inside the U.S. Provisions don‘t apply here if issuer elects to really solely on Regulation D for offers or sales made to persons outside the U.S. Rule 501: Definitions and Terms Used in Regulation D i. Accredited Investor: any person who comes within any of the following categories, or the issuer reasonably believes comes within the following categories at the time of sale of securities to person 1. Any bank, savings and loan association, broker or dealer, insurance company, investment company, Small business investment company if assets in excess of 5M, mutual fund 2. Any private business development 3. Any non profit corporation, regular corporation, partnership (not one formed for specific purpose of acquiring the securities offered) assets in excess 5M 1. it can be partnership formed to make investments, just not one for this specific investment 4. Director, executive officer, or general partner of issuer of securities being offered or sold 5. Person whose net worth or joint net worth with spouse exceeds 1M 6. Person who had income in excess of 200K in last two years and reasonably expects to have that in the next year, or if joint in excess 300K 7. Trust with total assets in excess of 5M, not formed for specific purpose of acquiring these securities, whose purchase is directed by sophisticated person 8. Any entity in which all of the equal owners are accredited investors ii. Affiliate 1. A person that directly or indirectly through 1 or more intermediaries controls or is controlled by the persons specified iii. Aggregate Offering Price 1. Sum of cash, services, property, notes, cancellation of debt or other consideration to be received by an issuer for issuance of securities (when cash and non cash consideration giving offering price based on cash) iv. Calculation of Number of Purchasers 1. Following shall be EXCLUDED 1. Relative, spouse, or relative of souse of purchaser who has same principal residence as purchaser 2. Any trust in which purchaser and persons related to him have more than 50% of beneficial interest 3. Corporation or other organization of which purchaser and any persons related to him are beneficial owners of more than 50% of securities 4. Accredited investor 35 Regulation D tells transactions exempt from registration requirements of §5 of the ‘33 Act. However you aren‘t exempt from antifraud, civil liability or other provisions of federal securities laws. [Can be sued under 12(a)(2) of the ‘33 Act, 10(b) of the ‘34 Act. You can‘t provide information that is misleading. 2. 3. 4. 5. 6. Corporation, partnership, or other entity is counted as one purchaser 1. if organized for specific purpose of acquiring securities and isn‘t accredited investor, then count as separate purchasers Non contributory employee benefit plan is one purchaser Executive officer means president, VP in charge of unit, ,officer who performs policy making function Issuer is same as under 2(4) Purchaser representative means any person who satisfies all of the following conditions, or issuer c. Not affiliate director officer or other employee of issuer or beneficial owner of 10% or more of any class of equity securities (except where purchaser is relative of purchaser representative, or trust or estate in which purchaser representative have more than 50% of beneficial interest, or corporation where purchaser representative s beneficial owner of more than 50%) 2. Has knowledge and experience in financial and business matters that he is capable of evaluating alone or together with other purchase representative merits and risk of prospective investment 3. Acknowledged by purchaser in writing that the person is to be his purchaser representative 4. Discloses to purchaser in writing a reasonable time prior to sale of securities any material relationship between himself or affiliates and issuer or its affiliate Rule 502: General Conditions to be Met (this is where our focus is) i. 502(a) Offers and sales made more than six months before start of offering, or more than six months after completion of offering are not considered part of that offering so long as during six month periods are no offers or sale of securities that are of same or similar class as those sold under Reg. D (only can do employee stock option purchase plans) 1. Example: if on 1/1/04 is sale to 35 unaccredited investors, and 3/1/04 issuer sells to 1 unaccredited investor they would be considered part of one offering. 2. If you don‘t meet this safe harbor provision, there is no negative presumption, but you will have to fall back on the facts and circumstances test. 1. 502(a) Following factors should be considered to determine whether offers and sales should be integrated: a. whether sales are part of single plan of financing b. whether sale involves issuance of same class of securities c. whether sales made about same time d. whether same type of consideration received and e. whether sales are made for same general purpose ii. 502(b) Information requirements 1. When information must be furnished: 1. if issuer sells securities under 505 or 506 to person that is not accredited investor have to give following information: (not required under 504 or if accredited investor) a. Registration quality information. The higher the offering the more information that is required. 2. The SEC points out in FN in 502 that the information that you provide to unaccredited investors, you should consider providing to the accredited investors as well a. This is because although you are exempt from the registration provisions you are not exempt from the fraud provisions. So to protect yourself you may want to give to accredited investors so that they have the information in front of them and can‘t say that you didn‘t tell them something. iii. Limit on manner of offering (502(c)) 1. Neither issuer no person acting on its behalf shall offer to sell securities by any form of general solicitation or general advertising. Examples are, but not limited to 1. advertisement article, notice or other communication in magazine, newspaper, TV, Radio 2. Seminar/meetings where attendees have been invited by any general solicitation or general advertising 36 reasonably believes satisfies all of the following 1. d. e. f. g. iv. 502(d): Limit on resale: Stock sold in a private placement needs to come to rest in the hands of the purchaser. This means that the purchase should be purchasing for his/her own investment AND NOT FOR RESALE. 1. You can‘t resell the stock without registration under the act or exemption from it. 1. The people who buy, if they want to sell would be considered to be UWs. a. Example: Sale under Reg. D to purchaser X. X cannot in turn sell the stock unless he registers it or is exempted from registration under an exemption other than 4(2). b. 2(a)(11): term UW means person who purchased from issuer with view to distribution. So if they want to sell their Reg. D security it is like UW. 2. Except as provided in 504(b)(1) securities acquired in a transaction under Reg. D have status of securities acquired under 4(2) and can‘t be sold without registration under Act or exemption therefrom. Issuer should take care to make sure that purchasers aren‘t underwriters by doing the following 3. Reasonable inquiry to see if people acquiring for self or other persons. 1. often have them fill out a form 4. written discloser to each purchaser prior to sale that securities aren‘t registered and can‘t be resold unless registration or exemption 5. placement of legend on certificate saying that the securities hasn‘t been registered Parts IV and V i. For unaccredited investors, if you give different information to accredited, you have to have to give it to unaccredited ii. V: Everyone should get an opportunity to ask questions Rule 503: Filing of notice of sales i. Issuer offering or selling securities under 504, 505, or 506 has to file with omission 5 copies of notice on Form D no later than 15 days after first sale of securities ii. 1 copy of every notice on Form D signed by person authorized by issuer iii. if sale under 505 notice should say will give information on unaccredited investors Rule 504: Exemption for Limited Offerings and Sales of Securities not exceeding 1M i. Dollar ceiling: 1M (12 mos) ii. Number of investors: unlimited iii. Investor qualification: none required iv. Commissions: Limitations on manner of offering: General solicitation permitted if shares issue pursuant to 504(b) in one or more states that provide for registration of securities and require distribution of a substantive disclosure document sale. 1. ii) in states not so providing for registration or public filing if a substantive disclosure document meeting standard of a stat requiring registration is provided to each purchase before sale or 2. iii) exclusively to accredited investors pursuant to stat law exemptions that permit general solicitation and advertising v. Limitations on Resale: restricted unless sales pursuant to Rule 504(b) vi. Issuer Qualification: not available for reporting companies, investment companies, or ―development stage companies‖ lacking ―specific business or purpose‖ or having only a plan to engage in a merger or mergers vii. Notice of sale: Form D required 1. 5 copies filed with SEC 15 days after first sale viii. Information requirements: no information specified Rule 505 i. Dollar Ceiling: 5M (12 mos) ii. Number of investors: 35 plus unlimited accredited investors iii. Investor qualification: none required iv. Commissions: permitted v. Limitations on manner of offering: no general solicitation permitted vi. Limitations on resale: Restricted according to Rule 144 vii. Issuer qualification: no investment companies or issuer disqualified under Rag. A viii. Notice of sale: same as Rule 504 ix. Information requirements: if purchased solely by accredited, no information specified 1. if purchased by nonaccredited: non reporting issues must furnish 37 h. i. j. offering sup to 2M: non financial information, financial information up to 7.5M: information required in SB-2 except that if undue effort or expense required, issuer balance sheet must be provided Rule 506: No limit on amt. of money i. (b)(2)(i): no more than 35 purchasers, or issuer reasonably believes no more than 35 purchasers 1. Issuer reasonably believes is the belief standard through the provision. 1. means that as long as issuer tries to determine that it meets qualifications, presumed to have done so 2. investors have questionnaires, and if reliance upon it is reasonable the issuer is viewed to have reasonable belief 2. The group of accredited investors doesn‘t count either. 3. So in general, you do not count if you are sophisticated enough to understand, or the purchaser representative is able to evaluate for you. ii. Definition of accredited investor: also located above 1. bank, registered broker dealer, investment company (mutual fund), non profit corporation, corporation, partnership not formed for the specific purpose of acquiring securities if your partnership has assets in excess of 5M, 2. Directors and officers of the company 3. Person whose individual or joint net worth exceeds 1M 4. Person whose income has been in excess of 200K last two years and will likely be in excess the next year, 300K if joint return 5. Trust with assets in excess of 4M not formed for purpose of offering and run by sophisticated person 1. If you are represented by a purchaser representative you do not count either Rule 507: Disqualifying provision relating to exemptions under 505 and 506 i. You can‘t use if you or predecessor or affiliate has been subject to order, judgment of court preliminary or permanently enjoin person for failure to comply with Rule 503 Rule 508: if there is an insignificant deviation from the terms of the offering the SEC will forgive 1. 2. X. Intrastate Offerings: Section 3(a)(11) and Rule 147 a. The Securities Act is not implicated unless interstate commerce is involved. There is a jurisdictional threshold to the implication of the ‘33 Act. i. But the intrastate offering exemption assumes that you have offering or sale involving interstate commerce, but qualifies under the exemption. 1. Does involve use of facilities of interstate commerce—even call in state probably involves interstate commerce, but this may still qualify as intrastate offering exemption ii. 3(a)(11): 1. Any security which is part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within, or if a corporation, incorporated by and doing business within such State or Territory 1. means a DE corp. doing business in CA will not qualify for this exception 2. This exception is a so-called unlimited exemption in that a public offering is fine unless it is interstate 1. there are no accreditation requirements, it can be a public offering, it can be general solicitation 2. major limitation is that issuer and buyer must be residents of state where issue is happening iii. SEC Release 4434 states that the 3(a)(11) provision was only meant for local financing which may practicably be consummated in its entire within the State or Territory in which the issuer is both incorporated and doing business 1. We are given factors under this release of what to look for to see if it is a single issue. These are the factors for integration 1. Are offerings part of a single part of a plan of financing 2) do the offerings involve issuance of the same class of security 3) Are the offerings made at or about the same 38 b. time 4) is the same type of consideration to be received 5) are the offerings made for the same general purpose Rule 147 implements a safe harbor provision i. Again, as with all safe harbor provisions, it is not exclusive, and there is no negative presumption if you do not pass it ii. Securities Act Release 5450: this states that the SEC has adopted Rule 147 which defines and clarifies 3(a)(11). iii. There are four concepts in 3(a)(11). 1. Transaction concept: exemption only applies to that transaction, which means 1. a buyer buying under 3(a)(11) does not have stock that is exempt from further regulation under the securities laws 2. When he/she sells the stock, they will have to register it under the ‘33 Act or find another exemption under 4(2) or possibly use 3(a)(11). 3. The stock doesn‘t acquire a quality that exempts it forever 2. Part of issue concept 1. There are usually multiple sales of securities, multiple buyers. Each transaction must be 2. examined to see if they are exempt. They will be exempt if they are part of an issuer offered and sold only to residents of the state. 3. 4. The security has to be part of an issue that is an identifiable and separate offering of securities. a. This means that in the issue, every offer and sale within the issue must be to residents of that one state only. If you have one sale out of state, it destroys the exemption for ALL of the sales. This raises the integration issue: (pp. 514-519) a. Example: Ca Corporation wants to raise 20M. It decides it wants to do it under 3(a)(11). They only raise 10M in Ca. so they decide to do an offering in Utah. They do the Utah one under a 4(2), relying on 506. They sell 10M share to Ca, Az, and Nv residents, all whom are accredited. 1. The issue becomes whether there is one or two issues. a. The company will argue that it is two issues. But the SEC will say that this is one offering, and because of that it has flunked both the 506 and 3(a)(11) exemption so it is out of luck. b. The two transactions are integrated. b. We can have backward and forward integration. The example above is forward integration. The effects in the first transaction; go forward in time to destroy. 1. In Backward integration, interstate portion goes back in time to render the intrastate exemption unavailable. c. Backward integration: X corporation makes offering under 3(a)(11) which is followed by a ‘33 Act offering under an IPO. If the two are integrated, the public offering, which was registered, would infect the intrastate offering. Coming to rest is the second part of the issue concept: a. If issue sold to CA residents, and then is immediately resold to resident of other states, it has not come to rest in the hands of the CA resident so it will not be exempt under 3(a)(11) b. This does not mean that the purchaser has to hold forever. c. Subsequent resale will not nullify the initial intrastate if issue has come to rest in hands of the buyer—if the buyer has bought for investment and not for resale 1. In an intrastate offering, it is important to get representation and warranty from the buyer that they are buying for a LT investment and not for purpose of resale. 2. You need to look where the stock comes to rest. The issuer of CA could sell to NY UW who immediately sells to CA residents. We ignore the UW step b/c it didn‘t come to rest in hands of NY UW. This is 39 c. d. e. f. g. h. Note §18 exempt state offerings with national exchanges. This means that state blue sky laws don‘t apply to securities that are going to be registered on national exchange. i. §18 says that securities exempt under 4(2) are also exempt from the state securities laws, except that the state may require a filing of the notes (and also the fraud provisions of the state securities laws are not preempted). ii. However 3(a)(11) is an exception to the general rule SEC v. McDonald i. Fact: MN corporation with principal location in MN, and registered within the state rather than the SEC. The purchaser would have unsecured notes where the issuer issued unsecured demand notes. Company took the money raised and then made loans to non-MN borrows for real estate who would return secured mortgages in return. The corporation only had one office in MN, and the payments on the loans were made to MN. ii. Issues: did exemption apply in this case? No the exemption did not apply. iii. Reasoning: corporation was having money sent to MN, and business was in MN, but predominate business operations not in MN. 1. The predominant business operations must be within the state. Truckee v. Dunn i. Case of CA Corporation made offering to CA residents not build hotel in NV. (Not a case under 3(a)(11) in that not being used in NV). ii. This must be more than a di minimums amount of business in this case. Chapman v. Dunn i. Offering by MI Company to have oil interest in OH. ii. Two part test for the doing business requirement 1. issue must conduct a predominant amount of business within the same state and 2. the business the issue must conduct within the state is the income producing activity iii. Thus, the money raised in state offering must be used in the state business, rather than a new business outside of the state SEC release 5450 i. Business should be located in the state, and; 1. substantially all of the proceeds of the offering must be put to use in the local area ii. Four exemptions 1. if you have a transaction try to fit within the safe harbor provisions 1. 4(1) Rule 144 2. 4(2): this can be used post transaction in that it is too late to argue from the rule 3. 506 4. 147 Rule 147 [A safe harbor rule, providing exemption. As with all safe harbors, there is no negative presumption if you cannot meet the requirements of this rule and you may fall back on 3(a)(11) i. Transactions covered: 147(a) 1. Rule provides that offers, offers to sell, offers for sale, and sales of securities that meet all conditions of rule will be deemed to come within exemption provided by 3a11. Those conditions are: 2. 1) Issuer must be resident and doing business within the state or territory in which securities are offered and sold 2) offeree and purchaser must be resident within such state or territory 3) resale‘s for a period of 9 months after the last sale which is part of an issue must be limited as provided. 3. In addition the revised rule provides that certain offers and sale of securities by or for the issuers will be deemed not par other issue for purposes of the rule only. 4. 3(a)(11) exempt §5 from registration provision but not the anti fraud provisions. The exemption was intended to apply to issuances genuinely local in character. 5. There is no negative presumption under this rule so you can still fall back on 3(a)(11). 6. The persons claiming available of this rule has the burden to prove that they are eligible for the exemption. 7. The rule doesn‘t establish exclusive standards, and you can rely on the statute. 40 risky, however, b/c if the UW can‘t sell and securities are in his hands you lose your exemption. ii. part of issue 1. Securities of issuer which are part of issuer must be offered, offered for sale or sold in accordance with the rule. 2. all securities of the issuer offered, offered for sale or sold pursuant to exemption provided under 3 or 4(2) prior or subsequent to 6 month period will be deemed not part of issue provided no offers, offers to sell or sale of securities if the same or similar class by or for issuer during the six months periods 1. rule provides an exemption for offers and sales for issuer only a. thus, narrower than 3(a)(11) in that it only applies to issuer where the other rule can apply to controlling shareholders and issuers 2. Determine what offers and sales are part of the issue, and all of these offers or sales must meet 147 to be exempt a. This is the integration issue. SEC says generally they look at five factors on p. 80 to determine if there is integration 1. Are the offerings part of a single plan of financing, do the offerings involve issuance of the same class of securities, are the offerings made at or about the same time, is the same type of consideration o be received, and are the offerings made for the same general purposes b. If the integration analysis is too vague you can rely on safe harbor rule under 147(b)(2): page 81 1. This is similar to the 12 month rule under Reg. D, but slightly different 2. ―issue not be deemed to include offers, offers to sell, offers for sale or sales of securities of the issuer pursuant to the exemption provided by §3 or 4(2) that take place prior to the six month period immediately preceding or after the six month period immediately following any offers, offers for sale, or sale pursuant to this rule, provided that there are during either of said six month periods no offers, offers for sale , or sales of security by or for the issuer of the same or similar class as those offered, offered for sale or sold pursuant to this rule a. if you meet this safe harbor standard, offers or sales won‘t be integrated b. if there is a 147 sale of offer which occurs more than six months after or before, it will not be taken into account i. Only certain offers and sales made outside this time period will not be taken into account. These include: ii. other 3a11 interstate sale made before or after this period iii. private placements under 4(2) iv. registered IPO‘s under 5 c. AND for any of these there can‘t be other sales during the 13 month period. i. If you want to rely on this safe harbor, the sale or offer must fit into 1/3 categories, or if it is within the 13 month period ii. if it does not fit within these categories, you must fall back n the common law five factor test iii. Nature of Issuer 147(c)(1): person resident within 1. Provides specifically that a corporate issuer must be incorporated in the stat 2. general partnership or other form of business entity that is not formed under a specific state or territorial law must have its principal office within state or territory 3. individual deemed issue (promoter issuing preincorpaotin certificate) deemed resident if his principle residence is in state or territory iv. Nature of issuer: doing business within 147(c)(2) 1. issuer will be deemed doing business within state if 1. at least 80 percent of gross revenues and those of its subsidiaries are within state 2. at least 80% of assets and those of subsidiaries are in state 41 2. Examples for doing business within the state: 465-67. The SEC has adopted a liberal approach as to doing business within the state. 1. X corporation incorporates in A, has its only warehouse, only manufacturing, and only office in that state. Only business is selling products through U.S. and Canada through mail order. X mails catalogs from office to residents of most states and provinces. Orders filled and shipped from X‘s warehouse to customer. All product manufactured by X in plant in state A. a. Is X deriving more than 80% of gross revenue from operation of business? Yes. 2. Assume same facts as 1 except x has no plan and purchases produces from corporations in other states. a. It is still doing business within the state. Y Corporation is incorporated in B and has its only office in that state. Y‘s only business is selling undeveloped land located in C and D by means of brochures mailed from its office throughout U.S. a. There are not sufficient facts to tell if Y is driving more than 80% of gross Doing business within satisfied. 3. 4. 5. Z is firm of engineering consultants organized under laws of E and with its only office in thatch state. During any year Z will provide consulting services for projects in other states. 75% of Z‘ work in terms of man hours performed at Z‘s offices Z has no employees outside of E, however professional personnel visit project sites and clients in other state. 50% of Z‘s revenues ids derived form climate outside of E. a. E meets the doing business requirement. Facts same as Z except in additional 25% of asset represented by A/R of clients outside of states. a. Z satisfies asset requirement. For purpose of rule, A/R arising form business revenues from the operation of a business or of property or rendering of services. i. Rules 152 and 155 are helpful in integration. 1. Rule 152: was implemented for issuers who were afraid that the private offering would be integrated with the public offering. a. Scenario: private placement (i.e. VC offering), followed by successful public offering b. The rule states, ―the phrase transactions by an issuer not involving any public offering in 4(2) shall be deemed to apply to transactions not involving any public offering at the time of said transactions although subsequently thereto the issuer decides to make a public offering and/or files a registration statement. c. This rule states that if the public offering is not contemplated at the time of the private offering (meaning that there are no definite plans to make the offering in the next month), but the public offering comes about through changes in circumstances (such as unanticipated business development, or a change in the market) the two will not be integrated i. In general, when you do the private offering, you contemplate that sometime in the future you will do a public offering, but you are not going to do it NOW 2. Rule 155: this is helpful when you abandon the private or the public offering. a. Scenario: You do not have enough takes for the private placement, but then there is a favorable market switch. The question becomes will the previous private offerings be integrated with the subsequent public offering. i. If you have abandoned the private placement followed by the public offering and sale, you could have backward integration (meaning that if it is viewed as one offering, you could be viewed as violating the law by making offers to sell without filing the registration statement) b. Safe harbor in 155(b): Abandon private followed by a public i. As long as you didn‘t sell securities in the private offering, and terminated all sales efforts under the private placement, and as long as you tell in your prospectus (both preliminary and final), then there will be no integration 42 conducted in the sat would generally be considered to be located at principal office of issuer. c. ii. There must be a 30 day grace period between the public and private UNLESS ALL OFFEREES WERE ACCREDITED OR SOPHISTICATED INVESTORS (exception found in 155(b)(4)). 1. If sales were intended to meet the requirements of 506 as opposed to just under 4(2) you don‘t even have the 30 day period—you could start the public offering, filing the registration statement on day 2 iii. just remember you can‘t have made any sales (even one sale will destroy this) Safe harbor in 155(c): abandoned registered public offering, then a private offering i. There you have no integration if no securities were sold in the registered offering. ii. The issuer formally withdraws the registration statement (files amendment to registration and withdraws it) iii. You have to wait 30 days, and there is no exception to this with accredited investors or anything. 1. you must tell individuals in the private placement that you did file a public offering and chose to withdraw it (full disclosure) XI. Offerings by UW, Affiliates, and Dealers: Resales a. Introductory Information i. §5 restricts sales without a registration statement. §4(2) then exempts the issuer‘s sale of stock in a private placement, and 3(a)(11) exempts issuances by the issuer selling to shareholders resident within state of incorporation. ii. §4(1) states that §5 only applies to issuers, underwriters, and dealers. This exempts transactions by all persons except those that fall under one of the three categories 1. Issuer: selling the stock (or other interest) in itself 2. Dealer: 2(a)(12): Dealer means any person who engages for either part or all of his time, directly or indirectly, as agent, broker, or principal, in the business of offering, buying, selling, or otherwise 1. broker: Takes agent for owner of securities 2. Dealer: someone who buys the shares in the hope of reselling for a profit 3. Underwriter: 2(a)(11): The term means any person who 1) purchased form an issuer or controlling person with a view to distribution of the security or 2) ay person who offers or sells of an issuer or controlling person in connection with the distribution of the security 1. there are two transactions contemplated with the distribution of security a. First part: Purchase where you actually take title and sell it: the typical broker house. They actually take title, and offer to sell for the issuer for a commission b. Second part: Or sell for exchange for a commission, but has to be in connection with a distribution 1. this is more like a best efforts offering: the issuer is selling to the public and the UW uses best efforts to locate people 2. The ownership of stock goes form the issuer to the public. The UW arranges for the sales and receives fee ii. Those excluded from the definition of an UW include 1. Doesn‘t include person whose commission is broker: offers or sells for an issuer in connection with a security is an UW. They receive a commission from the issuer. But if that UW in turn pays a commission to a dealer to sell stock for him, that 2nd person is not an UW and is merely a dealer. a. Example: Issuer sells to UW [best efforts offering, where the UW does not take title to the stock, but takes commission on shares sold, receiving commission from the issuer]. i. The UW engages a broker to also sell stock to the public, and the UW pays a commission to the broker not in excess of the normal commission. In this ii. Note, however, if the commission fee was in excess of normal fee he would be an UW. Remember, sales by affiliates (from rule 405 definition) is deemed to be sales by the issuer 43 situation, the broker is not considered to be an UW. b. iii. Included in the definition of the underwriter: 1. The entity receiving the brokerage fee from the UW is a dealer, commission from issuer = UW 2. Issuer also includes any person directly or indirectly controlling or controlled by the issuer 3. This is saying that a person controlling or controlled by issuer is considered to be an UW for the purposes of this definition only. 4. Example: Issuer sells stock to X, X is going to buy stock with view of distribution to the public. A owns 80% of the stock, and is the chairman of the board for company. He also sells stock to X and X buys for the purpose of distribution. a. If X were to buy from person owning only 1% of stock from the company, then the person owning 1% not considered to be an issuer b/c owns so little iv. Rule 405: Definition of a controlling Shareholder 1. Control means 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 contrast or otherwise 2. Control means that you have possession, either directly or indirectly through ownership of securities, through contract, or otherwise 3. If you have means to direct the corporation then you are in control a. Any person who can direct the management or policies, whether through ownership of v. Affiliate: Rule 506; Affiliate is a person who directly or indirectly controls the person specified. They are only an issuer for the purpose of finding an UW 1. 2(a)(11): person directly controlling or controlled by the issuer 2. This applies to people control the issuer, and controlled by the issuer. (defined as affiliates in Rule 405) 3. Example: The shareholder of issuer (a) sells stock. They have X do it and we need to figure out if X is an UW. a. Reason they are considered to be an issuer is: Legislative history: page 530 second paragraph b. Purpose of the statute is to give ―full disclosure, no fraud‖ i. The congress, in defining UW, said that the need is there whether sale by issuer or sale by affiliate. Theory: An affiliate, because he/she controls the issuer, has the clout to force the issuer to make the necessary disclosure. ii. Only entity can provide the disclosure required under securities laws Requirement of distribution i. If there is going to be an UW there has to be a distribution. If no distribution, then you do not have an UW. ii. Distribution is generally understood to be synonymous with a public offering. 1. Oklahoma Texas Trust: held to comprise the entire process by which in the court of a public offering the block of securities is dispersed and ultimately comes to rest in the hands of the investing public . SEC v. Chinese Benevolent Association i. Facts: Chinese government selling bonds, and defendant is NY Corporation that is soliciting people in NY to buy them. They aren‘t getting any money or commissions for the deal. Banks are the agents of the purchasers, getting the bonds to them. 1. Issuer = Republic of China 2. Bank = agent 3. Defendant = outsider that is solicitation ii. The SEC said that they were an UW 1. Fit under the second definitional prong of 2(a)(11): someone who offers or sells for an issuer in securities or otherwise is a controlling person b. c. connection with the distribution of a security a. The fact that the defendant had no relationship with the issuer and the fact that defendant received no compensation for its efforts is irrelevant d. SEC v. Guild Films i. Facts: Roach controls all corporations—owns stock in Jacobs who owns majority in Scranton, Roach Studios, WR Corp, and RabCo. 44 e. Roach, through his corporations, made contractual representation that buying for investment and not for resale. [court said his real intent was to have it resold] 2. Santa Monica Bank and Southwest Bank loan money to Roach and Roach gives a promissory note. He pledged Jacob‘s Corp Stock and the SEC put a stop to its trading on the NYSE. a. Roach then has to give them more shares, which he does in Guild, but these are stopped by the SEC because they are not registered. 3. The banks want to sell the stock and apply the proceeds to the interest, and want to sell to the public through brokers a. Court found that banks were underwriters i. They acquired stock with the view to sell, wanted to liquidate, and they had purchased for the purpose of selling to the public. ii. They purchased/acquired stock from the affiliate (Roach) for purpose of sale to public and purpose of distribution. iii. This really shows the broadness of the meaning of purchase: they did not even purchase, got it from a note from Roach b. The defendant banks are UW under the definition, and the burden of proof is on the one seeking the exemption to prove otherwise. c. Banks are purchasers, broadly defined, and direct dealing with the issuer is not necessary In re Ira Haupt & Co. i. Facts: Ira Haupt and Co. is a brokerage firm that the SEC wants to get kicked out of the NASD. They think he willfully violated §5, and this turns on whether or not Ira Haupt is an UW. 1. Park and Tilford is a company that issued a dividend payable in whisky. Schulte is a controlling shareholder owning 92% of the stock. Because he owns so much he is going to be considered an Schulte wants to sell and puts in standing order to sell shares and ends up selling a great deal. Haupt is alleged to have violated the securities laws by not registering the stock. a. Haupt would be an UW because he is help gin an affiliate distribute securities (this falls under the second definitional provision under 2(a)(11)). b. Affiliate Schulte is an issuer for the purposes of the definition of underwriter b/c he is an affiliate. ii. Haupt brings up a defense from 4(4): Provision of §5 shall not apply to broker‘s transactions executed upon customers‘ orders on any exchange or in the over-the-counter market but not the solicitation of such orders 1. doesn‘t work b/c 4(1) overrides 4(4) 2. 4(4) was intended for ―ordinary broker transactions‖ a. They would include a sale by a non affiliate of the issuer. Example: if you had a shareholder who owns only 100 shares and that is .001% of the company (versus Schulte who has 93% of the company). Shareholder owning .001 could sell b/c not an issuer, UW or dealer, and then Haupt is exempt b/c not offering or selling on behalf of an issuer. 2. 4(4) permits individuals to sell securities through broker normal brokerage transaction, even if during a period of distribution without regard of registration prospectus of §5 but the process of distribution itself, however carried out, is subject to §5. Who is in control--Rule 405: this rule defines control. i. The term control means the possession, director 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 1. The majority shareholder is in control 2. By contract: could be a proxy which gives someone who doesn‘t own stock, power to control the company, or person who has the power to vote shares of the company, or employment contract of the CEO (not an inclusive list) 3. The power to control is sufficient, even if it is no exercised a. Example in the Waslton case: the guy has voting control by owning majority of the stock, 4. Those without the power to control have it if they exercise it with the consent of those who have power, but choose not to exercise 2. 3. 1. issuer. He is an affiliate. f. but he is inactive. He his still in control, is still an affiliate b/c he has power to control. 45 5. 6. 7. 8. 9. g. 10. The ultimate test doesn‘t depend upon the bright line test, depends upon power a. Take into account history, family, shareholders, position, what group calls the day to day shots b. What group could if it wished call the shots c. When these are identified the controlling persons and group are identified ii. There are two situations that cause concerns after Haupt 1. ―Control securities‖ are securities held by affiliates [any stock held by affiliate of company is a control security] a. uncertainty as to how much could be sold by controlling persons in a broker‘s transaction without registration 2. Restricted Securities a. Those purchased in offering qualified under regulation D are restricted in that they must be for investor‘s own resale. Theory being: issuer selling to X, X sell to public i. This puts X as the underwriter, b/c bought with the view for public distribution b. Rule 506 imposes restrictions imposes restrictions; you can‘t sell stock, must buy for investment. You have to hold it, legends on the stock, and so on. c. Restricted applies to securities purchased by persons in a non public offering under 4(2). Rule 144: tells for control or restricted shares—when they can cash out without filing a registration statement i. Safe Harbor: If you meet its requirements, the sales will be exempt under the broker‘s exemption of 4(4). The affiliate or person selling the control stock or restricted stock [i.e. private placement]. Question is whether the purchaser is an UW in a subsequent sale to the public. 1. Rule 144 states that people selling exempted under 4(1), brokers exempted under 4(2) and 4(4) b/c not UW and meeting brokerage transactions. ii. Preliminary note: where adequate current information concerning the issuer is available for the public, Rule 144 permits the public sale in ordinary trading transactions of limited amounts of securities owned by persons controlling the issuer and by persons who have acquired restricted securities of the issuer iii. In determining ordinary brokerage or issuing 1. purpose of underlying policy of act: availability of rule is based on adequate current public information 2. holding period prior to resale: have assumed economic risks of investment and aren‘t acting as conduits for sale to public of unregistered securities 3. Impact of transaction on the trading market a. Only meant to exempt routine trading transactions b. Not intended to exempt issuer or other acts of people for distribution c. Must sell securities in limited quantities and in such a manner as to not disrupt the trading market d. Limited quantities in broker transactions (unsolicited offers from the public) i. Quantitative information and quality (only certain types of sales, selling activities) For example, there is a person who has control but does not exercise it, and gives it away (either expressly or by acquiescence) and both are viewed as having power Directors are viewed to have power You can have power without owning stock, and therefore be an affiliate 10% of ownership in a public company is a red flat—this may be effective for control, depending upon the distribution of shares a. The SEC has a rebuttable presumption that in a public company, any 10% shareholder is an affiliate b. However if one person owns 90% and other r10% the 10% will not have control Officer or director: small ownership or no ownership of shares may be relevant b/c looking at the definition of control, they do have power to control the management and direction of the corporation Control Group: group of people who control a. Officers and directors as a group control the corporation, and all members of the group will be an affiliate b. Members of a family may be a control group a. 46 iv. Substantive Rule is from 144(b) [deals with whether the seller or the broker is an UW if seller or broker is UW, it is subject to §5 of ‘33 Act] 1. Any affiliate or other person who sells restricted securities of an issuer for his own account a. Any affiliate or other person means anyone. Any person who sells restricted securities of an issuer of his own account 3. or any person who sells for affiliate a. Any stock that an affiliate holds. An affiliate could hold stock that, in itself, is restricted securities. b. Whether or not the stock is restricted 4. Shall be deemed not to be engaged in a distribution of securities and not an UW within meaning of 2(a)(11) of the act if all conditions of the rule are met XII. Rule 144 a. Implications/substantive rule: anyone who sells securities and meet the following requirements will not be viewed as an underwriter. i. Furthermore, any person who sells securities for the account of an affiliate won‘t be viewed as an UW. b. Conditions of Rule 144: allows you to sell stock that is restricted or control to the public i. 144(a): Definitions 1. (1) Affiliate: person that directly or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with such issuer 2. (3) Restricted securities are: 1. (i) Securities acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a transaction or chain of transaction not involving any public offering a. This means restricted security is one acquired in a private placement under 4(2) or under 506. b. Example: issuer sells to X in 506 or 4(2). Then, if X sells to Y, under 4(2) or 607, it would be the equivalent of a private placement [but it doesn‘t go under 4(2) b/c X is not an issuer, and have to be issuer to use 4(2) ] It is the substantive equivalent of the private placement 1. if you acquire stock in private placement, or equivalent thereof, and are subject to 144 on resale 3. (ii) Securities acquired from issuer that are subject to resale limitations of 502(d) under Regulation D 1. Regulation D is restricted. 502(d) states that stock cannot be sold without registration under the Act or exemption therefrom. The issuer shall exercise reasonable care to assure that the purchaser of the securities are not UW within the meaning of 2(11) by doing the following: a. 1) Reasonable inquiry to determine if purchase is acquiring the securities for self b. 2) Written disclosure to each purchase prior to ale that the securities haven‘t been registered under the Act c. 3) Placement of a legend on the certificate or other document that evidences the securities, stating that they haven‘t been registered under the Act. c. Four or Five [depending on if restricted or control] requirements that you have to meet i. 144(c): Current public information: available adequate current public information 1. you need forms that would be filed with the SEC (10K, 10Q, 8K) 2. As a practical matter, you must be a reporting company for shareholders to use Rule 144 1. This would mean anyone on the ‘34 Act a. More than 10M in assets, 500K shareholders b. IPO c. Trading on a National Exchange 3. Also, a significant number of companies will voluntarily register so that the shareholders can take advantage of Rule 144 ii. 144(d): Holding period [only restricted securities have a holding period requirement. Control securities aren‘t restricted securities] 47 (1) General rule: minimum of one year must elapse between the later of the date of acquisition of securities from issuer or affiliate of issuer, and any resale of such securities in reliance on this section for the account of either the acquirer or any subsequent holder of securities. If acquirer takes securities by purchase, one year period begins when the full purchase price or other consideration is paid or given by person acquiring the securities. 2. (2) Promissory notes: giving Seller from whom securities were purchased promissory note or other obligation to pay, or entering into an installment purchase contract with seller not deemed full payment unless: 1. (i) provides for full recourse against the purchaser of securities 2. (ii) is secured by collateral, other than securities purchase, having FMV at least equal to the purchase price of securities purchased and 3. (iii) shall have been discharged by payment in full prior to the sale of the securities 3. (3) Determination of holding period: 1. (i) Stock Dividends, Splits, and Recapitalizations: securities acquired from issuer as dividend or pursuant to stock split deemed to have been acquired at same time as securities on which dividend or if more than one, the initial dividend paid, 2. (ii) conversion: if securities sold were acquired from issuer for consideration consisting solely of other securities of the same issuer surrendered for conversion, securities acquired shall be deemed to have been acquired at same time as securities surrendered for conversion 3. (iii)contingent issuances of securities: securities acquired as a contingent payment of purchase price of equity interest in business sold to issuer or affiliate shall be deemed to have been acquired at time of sale if issuer or affiliate was then committed to issue securities subject only to conditions other than payment of further consideration. 4. (iv) Pledged Securities: securities which are bona fide pledged by affiliate of issuer when sold by pledge or purchaser , after default in obligation secured by pledge, shall be deemed to have been acquired when acquired by pledgor 5. (v) Gifts: securities acquired from affiliate of issuer by gift deemed to have been acquired by donee when they were acquired by the donor 6. (vi) trusts: where trust settler is affiliate of issuer, securities acquired from settler by trust or acquired from trust deemed acquired when acquired by settler 7. (vii) estates: where deceased person was affiliate of issuer, securities held by the estate of such person or acquired from estate deemed to have been acquired when they were acquired by the deceased person, no holding period required if estate is not affiliate of issuer or securities sold by beneficiary or estate who is not affiliate iii. 144(e) Limitations on amount of Securities Sold: only have an UW if you have a distribution (public offering) meaning some kind of volume. Selling a few shares isn‘t a distribution. 1. (1) Sales by affiliates: if restricted or other securities are sold for the account of an affiliate of the issuer, amount of securities sold, together with all sales of restricted and other securities of same class for account of person in preceding three months (within the three month period ending on date of sale in question) Can‘t exceed greater of 1. i) 1% of shares or other units of class outstanding 2. ii) Average weekly reported volume of trading or reported through automatic quotation system: (NYSE or NASDAQ) not greater than average weekly reported volume 3. iii) average weekly volume in the OTC market 2. (2) Sales by non affiliates 1. Same volume restrictions, except if you meet conditions of 144(k) then you don‘t‘ have to worry about the requirements 2. 144(k) states that if non affiliates hold the security for at least two years, none of the requirements apply iv. 144(f): Securities shall be sold in brokers transactions within meaning of §4(4) of the Act or in transactions directly with a market maker and person selling securities shall not 1) solicit or arrange for solicitation of order to buy securities 2) make any payment in connection with offer or sale of securities to person other than broker who executes order. 1. Brokers Transaction: executed upon customer orders, but not solicitation of such orders (wait for orders to come in) 48 1. i. ii. v. vi. vii. Market Maker: dealer who maintains an inventory of stock and holds itself open on a continuous basis as being willing to buy or sell stock at current market price 3. Notice: seller of securities (affiliate) may not take active steps in selling the securities (no promotional activities, etc.). Stock must be sold in brokers transaction within the meaning of 4(4) or in transaction directly with market maker 1. 4(4): Broker‘s transactions executed upon customer orders but not solicitation of such orders (waits for orders to come in from buyers). 2. market maker: dealer who maintains an inventory of stock and holds itself open on a continuous basis as being willing to buy or sell the stock at the current market price Notice that seller of the securities (the affiliate) ma not take any active steps in selling the securities— no promotional activities by the stockholder, or make any payment for selling except to person who executes). What we have is a shareholder/broker relationship, and broker receives normal customary fees and seller doesn‘t try to get people to drum u p interest in the stock. 1. passive broker: implied by the definition of broker‘s transactions, and also 2. passive (g) Brokers Transactions: 4(4) of act shall be deemed to include transactions by broker in which broker 1. (1) does no more than execute order or orders to sell securities as agent of person whose account securities are sold, receives no more than customary commission 2. (2) doesn‘t solicit or arrange solicitation of customer, but 1. if inquiries by broker or other brokers within proceeding 60 days, you can contact them 2. you may contact existing customers if indicated interest in last 10 days 3. OTC market: where informal bidding arrangement and advertise bid and ask 3. (3) Broker has to engage in due diligence: reasonable inquiry that the seller meets the requirement of Rule 144 a. Broker is policeman to make sure compliance with 144 b. Given some slack by words after reasonably inquiry. i. Has to be diligence on the part of the broker. After reasonably inquiry is not aware of circumstances indicating that person for whose account securities are sold is UW with respect to securities laws or that transaction is part of distribution of securities of issuer. ii. Reasonable inquiry required should include but not limited to: 1. (a) length of time securities have been held by person 2. (b) nature of transaction in which securities were acquired 3. (c) amount of securities of same class sold during past 3 months by all persons whose sales are required to be taken into consideration 4. (d) whether such person has solicited or made any arrangement for solicitation of buy orders in connection with proposed sale of securities 5. (f) whether such person has made any payment to any other person in connection with proposed sale 6. (g) number of shares or other units of class outstanding or relevant trade volume iii. Brokers needs to get representation letter from seller, and may rely upon that letter if reliance would be reasonable 1. Standard letter used by brokerage firms, goes through requirements of 144 and gives representation to seller (h) notice of proposed sale: you file form 144 with the SEC, basically a fill in the blank form (j) Non exclusive rule: you can fall back on the statue 1. doesn‘t eliminate or affect availability of any exemption for security that person may be able to rely upon 2. Can rely upon 4(1) with exempts all issuers UW and dealer. If no distribution don‘t have an UW 1. Example: restricted stock held by affiliate, sells stock to X in transaction that would qualify as a private placement if in fact stock had been sold directly by issuer. X has all information needs. a. Would go under 4(2), but 4(2) doesn‘t apply to shareholder. Therefore we call it a 4(1 ½). 49 2. 2. 3. 3. The public resale will involve a distribution, and whenever there is that distribution, we will have an UW. (Think Haupt—sold in small sales, but because they were part of a distribution to the public, his broker was an UW). Therefore you use the 4 (1 ½) exemption, which means that you are selling in a private 4. 5. 6. 7. 8. Want to avoid the UW classification for the individual selling stock—think about these factors 1. Does the transaction involve a distribution? If no, then there is not an UW. a. If there is no UW involved in the sales transaction, then 4(1) is available and the shareholder is falling into the ―everyone besides broker, UW, or issuer category‖ b. Secondly, did the broker or agent sell the security for an affiliate? 1. If he did this and there was a distribution he is an UW. The Valueline Case (page 576 of the text) 1. This same result would apply whether they are control or restricted securities. 2. Facts: Marcus (Affiliate/Shareholder, Δ), and Vanco (intermediary/broker, Δ) Valueline (purchaser, Π) a. Marcus was an affiliate and sold ½ of his shares of stock (substantial amount), and Vanco was his broker. Valuline was the buyer, and is now suing for fraud under rule 10(b)(5) of the ‘34 Act, and §17 of the ‘33 Act. Also seeks rescission under 12(a)(1). 1. You may only get rescission if there is a public offering of securities that should have been registered, but can always use fraud even if you are exempt from registration. 3. Issue: Whether Vanco is an UW. Answer is NO. a. Vanco sold the stock for affiliate, and have to see if it is in connection with a distribution, which ultimately turns out not to be a distribution. Reasoning: the purchasers were highly sophisticated buyers. They were a mutual fund company, buying and selling stocks for a living. They had plenty of information, and therefore the court said that it was not a public offering. 1. They had access to information. 2. Doran tells us that it is private placement if sale made by an issuer. 3. Ralston Purina says no need for protection of securities laws b/c can fend for selves. HYPO: What if Vanco had bought the stock from the UW, and then sold it to Valuline in a private placement? 1. Vanco is not buying with a view to distribution—they are buying for a private sale. Therefore, there is not going to be an issue with distribution. So it would be fine. Note: Valuline will also be able to sell this stock that is restricted—they will follow Rule 144. 1. If Valuline were purchasing in the original offering for public distribution, it would mess up the entire transaction and taint it, and would thus be an illegal offering. Summary 1. Appropriate exemption provision is 4(1), and not 4(2) because 4(2) isn‘t used for issuer 2. There is no particular holding period required a. We are looking for view to distribution 3. Purchaser‘s sophistication and access to information appear to have been viewed as essential in the decisions a. You need this under 4(2) 4. The number of purchases, viewed alone, is not disparities of the availability of the exemption a. With any private placement, the amount of oferees is not what we are looking at. However, greater number of offerees tends to be public. You need to look at the type of investors that you have. 5. Restriction on resale by a purchase generally has not been required, and no decision has articulated an affirmative duty on holder‘s providing registration-type information to a purchaser a. Be careful with these—don‘t‘ rely upon good fortune of past defendants 50 transaction, a private sale that would be governed under 4(2) if you were an underwriter. 1. 2. 9. 2. BIG CONTEXT 1. Resale of restricted securities: i. public resales: Rule 144 is the only safe answer ii. private resales are possible in a 4 (1 1/2) is a private placement, would truly be private placement Distribution a. Is there a distribution analysis. i. Will the transaction involve distribution. If no then no UW ii. If no UW then 4(1) is available. b. There is the though that, under the law, if selling through the public through a broker selling 5 shares [small amt], intermittent and sales of shares in miniscule amounts should NOT cause the affiliate to be viewed as an UW. i. This is 4(1). You have problem, though b/c broker, even on intermittent sales, the broker is selling stock to public for affiliate. Even if affiliate is not viewed as an underwriter, the broker is more likely to be viewed as an underwriter. ii. Broker would say: if affiliate isn‘t UW why should I, as the broker, be. iii. B/c of 144, people do to rely upon this. prudent to impose resale restrictions on the purchaser because if that person is buying stock with a view to distribution/selling to the public, then he is an UW and the transaction is not exempt a. The coming to rest concept: if it is a private resale, if the purchaser is a mere conduit to the public, then the whole transaction chain may be viewed as a distribution Doran and Ralston Purina make it clear that the kind of information disclosed to the purchaser or to which the purchase has access must be registration quality information 51