Exam No. ________________
PEPPERDINE UNIVERSITY SCHOOL OF LAW FINAL EXAMINATION: Securities Regulation FALL 2004 PROFESSOR Bost Total No. of Questions: 3 Total No. of Pages: 8 Time: Three Hours
______________________________________________________________________________ INSTRUCTIONS 1. Please explain your answers fully and provide relevant authority (e.g., case, statute, regulation, form, release) when appropriate. For this examination, you may use your casebook, your statutes, rules and forms book, your class notes, any handouts that I have provided to you, and any outline on which you have worked or to which you have contributed. No other material is allowed. Time estimates for the questions are as indicated. Please place all blue books, scratch paper and the examination inside the front cover of the first blue book you use. If you are using a computer, please insert the exam, scratch paper and the ExamSoft disk in the envelope provided. These materials must be turned in or you will receive no credit for this exam. Thank you for your cooperation in the class. I wish you the very best.
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Question One (One Hour, Fifteen Minutes) Page 1 of 9
Vero Derby Inc. (AVero@) is an entertainment company founded twenty years ago by Cey, a legendary sports and entertainment personality. From small beginnings, Vero has become the nation=s leading roller derby promoter and operator, staging live events in arenas across the country. Vero has syndicated nationally a weekly roller derby show (ADerby Saturday Night@) and conducts periodic pay television Aderby-thons@ (ADerby is War@). Cey=s entrepreneurial genius is evidenced by the Astory-lines@ which he has developed in which recognized popular, or despised, characters (e.g., AIce Cold Claude Webster@ and AThe Pebble@) engage in weekly morality plays involving the struggle between good and evil. Cey and his longtime business colleague Garvey have been Vero=s Chief Executive Officer and Chief Financial Officer, respectively, from its founding. Cey and Garvey own 75% and 25%, respectively, of the capital stock of Vero. Vero=s financial progress has been steady, with gross revenues topping $80 million in its fiscal year ending September 30, 2004. However, in the past few years, Vero has incurred shortterm debt, bearing relatively high interest rates, of almost $60 million. Cey and Garvey are quite interested in either refinancing that debt with long-term bank debt at lower interest rates or liquidating the debt with the proceeds from a public offering of common stock. Further, they would like to raise, either by new borrowing or a public stock offering, another $10-to-$15 million for office and plant expansion and working capital. If the latter route were chosen, Vero would consider seeking the listing of its stock on NASDAQ. Regardless of the financing alternative chosen, Cey is determined to retain Atotal control@ of Vero and Aabsolute@ freedom of action so that Vero can successfully adapt to its difficult and often brutal business environment. Cey is by nature secretive and he despises second-guessing. He notes, AI=m the boss. Period! Close quote!@ However, finance is one area in which Cey=s confidence fades. He confesses to not understanding financial statements in the least (AI don=t know a debit from a credit@) and places full trust in this area in Garvey and no one else. Incidentally, Cey and Garvey view Vero=s management team as being thin and overworked and would like to attract two or three new marketing executives. The following events occur in chronological order: A. You are Vero=s outside corporate counsel and have been so for about ten years. You are well acquainted with the facts summarized above. You meet with Cey and Garvey to discuss Vero=s financing alternatives. They ask you for your opinion as to which alternative should be chosen. You remind them that you are not an investment banker or otherwise an expert in corporate finance and that they should consult with someone with such expertise. However, you agree to share your general impressions, based on your experience as a corporate lawyer, with them. B. Cey and Garvey meet with officers of Lopes Securities Co. (ALopes@), a respected national underwriting firm, to discuss the sale of Vero common stock to the public. In an attempt to determine whether a Vero stock offering is feasible, officers of Lopes telephone other investment bankers across the country, as well as several prominent regional retail securities broker/dealers, and discuss the possibility of working together on an offering. Vero and Lopes then sign a letter Page 2 of 9
of intent for a firm commitment underwriting to be managed by Lopes. The offering is to be 8,000,000 shares of common stock at $10 a share. C. Lopes distributes a press release to the Wall Street Journal and several other major newspapers announcing the forthcoming Vero common stock offering to be distributed through a national underwriting syndicate that it will lead as managing underwriter. The release also briefly indicates the general nature of Vero’s business and states that a registration statement under the ’33 Act has not yet been filed. D. Cey appears on CNBC=s evening talk show, AMarket Update,@ which does a regular weekly segment on upcoming IPO’s. During his appearance, of less than five minutes duration, he engages in an enthusiastic, but general, discussion of Vero=s business and mentions the possibility of a public offering of Vero’s common stock. E. Vero opens a new interactive website, featuring bold new graphics, product (e.g., skates, action figures) and ticket promotion, television schedules and a chat room for all Aderby heads@. The site trumpets roller derby as being Atomorrow=s sport today.@ The site prominently features a lengthy profile of Cey in which his long career in the business and his plans to make the “sport even bigger and better” are described. F. Within a few weeks, a registration statement covering the above-described stock offering is filed with the SEC. Lopes posts the preliminary prospectus on its website together with an announcement of the filing of the Vero registration statement. The announcement contains excerpts of information from the preliminary prospectus concerning the amount and type of stock to be sold, a short description of Vero=s business and a statement about Vero=s plans for the future. G. Employees of Lopes telephone, write and e-mail prospective underwriters and dealers attempting to line up support for the offering. A number of the prospective underwriters and dealers respond favorably, with a typical response being, APut me down for [a specified number of] shares.@ H. Cey again appears on CNBC=s AMarket Update@ show where he enthusiastically discusses Vero=s business and the proposed offering. Some time later, the AMarket Update@ segment is transmitted via the Internet in an Aelectronic road show@ format. A reporter for a newspaper in Des Moines logs in to the Internet presentation and writes an article in which Cey is quoted extensively. The article is published in her newspaper the next day. I. Basgall Securities Inc., a prominent regional securities dealer, which is aware of the pending Vero common stock offering but does not intend to become part of Page 3 of 9
the underwriting syndicate or dealer group, discusses the prospects of Vero in the weekly market letter that it distributes to its regular customers and recommends the Vero common stock as a long-term investment. J. Shortly after the filing of the registration statement, you, as issuer’s outside securities counsel, become aware that a spectator at a recent derby-thon has filed a personal injury lawsuit alleging serious injuries resulting from Vero’s negligence (failure to provide an adequate safety barrier to separate speeding skaters from spectators) and seeking compensatory damages of $1 million, plus punitive damages in an unspecified amount. You advise Vero’s in-house counsel Rau that the lawsuit should be disclosed in the registration statement. He responds that Vero has meritorious defenses but that he will seriously consider your recommendation. K. Shortly after Vero receives and responds to the last of the SEC=s comments, Vero and Lopes sign the underwriting agreement and the registration statement becomes effective. The final prospectus is posted by Lopes on its website. Some dealers= salespeople, at the time that they seek stock purchase order confirmations, advise customers that the final prospectus is available on the Lopes website. L. Lopes publishes an advertisement in the Wall Street Journal, containing the name of Vero and of all of the underwriters (but giving no addresses), stating that 8,000,000 shares of common stock are being offered at $10 a share and that this is a Anew issue@. M. Lopes provides to its salespeople a short memorandum that summarizes information from the final prospectus. A number of salespeople give this memorandum to customers, either by itself or together with a copy of the final prospectus. Determine the application of Section 5 of the =33 Act to the events described in each of the lettered paragraphs above. Please discuss. In addition, with regard to the events described in paragraphs A and J, please discuss generally your response to your client. (In all cases, assume that the Ainterstate commerce/mails@ jurisdictional means have been used.)
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Question Two (Forty-five minutes) Two-A. Smith & Lacy is a successful Los Angeles law firm, with five partners and nine associates. The firm=s practice is focused in the healthcare, general corporate and business litigation areas. The two named attorneys, Smith and Lacy, each have had an annual income over the past several years in the $175,000 range and the net worth of each is about $900,000. Smith, whose specialty is healthcare law, has traveled widely and has a diversified investment portfolio. Lacy, who is a corporate lawyer, has an interesting and somewhat unusual background. He graduated with a B.S. in Agriculture from a midwestern land-grant college and managed a large wheat and soy farm before deciding to go to law school. One day while reading the Wall Street Journal, Lacy is surprised to see a small advertisement in which an old friend named Hooten offers for sale interests in a jojoba farm located near Yuma, Arizona. The advertisement helpfully explains that the jojoba is a small shrub or tree with edible seeds that yield a valuable liquid wax primarily used in the manufacture of cosmetics. Intrigued, Lacy calls his old friend and, shortly thereafter, Hooten travels to Los Angeles and makes a sales presentation to all of the partners and associates of Smith and Lacy, offering for sale interests in a new business entity (the “Venture”) that would buy and operate the jojoba farm. Hooten supplements his oral presentation by handing out a journal article by an ASU agriculture professor on the general economic prospects of jojoba production, together with a three-page schedule showing projected costs and revenues over the first ten years of the Venture’s operation. No other written materials are distributed. After a visit to the Yuma farm site, Smith and Lacy, the highest earning and wealthiest lawyers in the firm, each decide to invest $625,000 in the Venture (with most of the investment being financed by bank borrowings). (The other partners and associates of the law firm, having never forgiven Smith for recommending that they buy Enron stock in August 2001, decline the investment opportunity.) The Venture is a general partnership. Under the partnership agreement, Smith, Lacy and Hooten are general partners, each with a one-third interest in profits and losses. Although the agreement gives Smith and Lacy, as owners of a majority interest in the partnership, control of the partnership and its farm operations, they are, in fact, passive and uninvolved in farm operations, receiving periodic reports from Hooten. Within a year, Smith and Lacy are disenchanted with their investment. Farm earnings have been sharply reduced by the voracious appetite of the Adesert mite@, a microscopic insect native to the Yuma area whose natural habitat is the jojoba plant. Eradication of the pest has proven difficult because of restrictive environmental laws. Further, farm operations are more costly than expected, raising the possibility that additional capital may be required. Two-B. Assume the same facts as in the first, second and fourth subparagraphs of paragraph Two-A above. Further, the Venture is a limited partnership in which Hooten is the general partner and Smith and Lacy are the limited partners, each with a one-third interest in profits and losses. The limited partnership agreement confirms Hooten=s Page 5 of 9
power and right to manage the business and affairs of the partnership as general partner but reserves to Aa majority in interest@ of the limited partners the power and right to veto the annual business plan to be submitted by the general partner, and to terminate the general partner=s interest in the partnership by buying out his interest for 110% of its appraised fair market value. Two-C. Assume the same facts as in the first, second and fourth subparagraphs of paragraph Two-A above. Further, the Venture is a limited liability company (“LLC”) in which Smith and Lacy each have a 49.5% interest and Hooten has a 1% interest, with profits and losses being allocated in accordance with such percentages. The LLC agreement provides that the LLC will be managed in accordance with the vote of a “majority of interest” of the LLC members. Simultaneously with its formation, the LLC enters into a ten-year farm management agreement with Hooten whereby Hooten agrees to manage the farm and receive an annual payment of $50,000 for his services. Two-D. Assume the same facts as in the first, second and fourth subparagraphs of paragraph Two-A above. Further, the Venture is a corporation in which Hooten owns all of the stock. Hooten sells his stock to Smith and Lacy for $1,250,000, with Smith and Lacy each buying 50% of the stock. Lacy, returning to his rural roots, decides to manage the corporation=s business himself, becoming its president and spending about one-half of his time on farm business in Arizona. Hooten is paid an annual salary of $10,000 for general consulting services, with a monthly time commitment not to exceed 20 hours. Two-E. Assume the same facts as in the first, second and fourth paragraphs of paragraph Two-A above. Further, Smith and Lacy decide not to purchase an equity interest in the Venture. Rather, after further discussion with Hooten, they each loan $625,000 to Hooten, with each loan being evidenced by an unsecured 10% promissory note due and payable in two years. Determine the application of the ’33 Act, including the civil remedies available to Smith and Lacy, to the events described in each of the paragraphs above. Please discuss. (In all cases, assume that the Ainterstate commerce/mails@ jurisdictional means have been used.)
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Question Three (One Hour) Baker Universal, Inc. (ABaker@) is in the household goods mail order business. Baker is incorporated in the state of California, with its office, warehouse and all other assets located in Tustin, California. Baker has about 525 shareholders and net assets valued at about $60 million. Baker’s stock trades in the over-the-counter market, although trading volume is light. Baker advertises its wares through its catalogs, published quarterly and mailed to hundreds of thousands of households throughout the western United States, and through its website. Customers place orders in one of three ways: by mail addressed to Baker=s Tustin office; by email addressed to, or website orders placed with, Baker, which accesses the orders by computers located in the Tustin office; or by toll-free telephone calls to the Tustin office. All shipments of goods are made from Baker=s Tustin warehouse. About 80% of Baker=s revenue is derived from sales made to customers not residing in California. About 70% of the goods sold by Baker are manufactured in states other than California. For several months in the fall and winter of 2002-2003, Baker has been engaged in discussions with the principals of Russell Merchandising Co. (ARussell@), one of Baker=s competitors in the mail order business. Russell, which is significantly smaller than Baker, is located in Downey, California, with 75% of its revenue being derived from sales to persons not residing in California and 85% of goods sold by it being manufactured in states other than California. All of Russell=s assets are located in Downey. The principals of Russell are nearing retirement age and, therefore, are interested in selling the company. Following weeks of negotiations, on January 31, 2003 Baker and Russell sign a non-binding letter of intent whereby Baker agrees to buy Russell=s assets for $18 million, with the purchase to close on April 30, 2003. Virtually simultaneous with the Russell negotiations are Baker=s efforts to buy from a bankruptcy estate for $6 million a state-of-the-art warehouse and distribution facility in Reno, Nevada. The cost of this facility is about 60% of the cost of constructing a similar facility in Los Angeles and would give Baker the additional facility it so desperately needs. On January 31, 2003 Baker enters into an agreement to purchase the Reno facility for $6 million cash, with the purchase to close on April 30, 2003. To raise the funds for the Russell and Reno facility transactions, Baker decides on an offering of $24 million of common stock intended to qualify for exemption under Regulation D Rule 506. On February 1, 2003 Baker engages Hough Securities, Ltd. (AHough@), a small Los Angeles securities firm, to advise and assist it in the offering. The offering commences on February 15, 2003 but within days is withdrawn by Baker and Hough because Russell, deciding that Athe deal just isn=t a good one@, terminates the letter of intent and suspends negotiations with Baker. Following hurried consultations, on February 18, 2003 Baker and Hough re-commence the stock offering on a reduced scale, with $6 million of common stock to finance the Reno facility purchase being offered for sale. The offering is quickly fully subscribed, with all sales of stock closing on March 15, 2003. All offerees (and purchasers) of the common stock are accredited investors, residing in California, Oregon and Nevada. The requirements of Regulation D Rules 502(b), (c), (d) and 503 are met. On April 30, 2003, Baker closes the Reno facility purchase. Page 7 of 9
In the first week of July 2003, discussions with Russell are reopened, with the previous barriers to the acquisition being removed through intense, good faith negotiations. By July 15, a deal is struck and a definitive agreement, providing for a purchase price of $18 million and a closing on September 15, 2003, is signed by the parties. Baker again consults with Hough about the financing of the Russell acquisition. After some consideration, Hough advises Baker to finance the acquisition by taking advantage of its strong local reputation and conducting an $18 million offering of common stock to persons residing in Southern California. Baker agrees. The offering commences on August 29, 2003, with offering materials prepared for the previous $6 million offering updated for circulation in this new offering. Hough immediately posts a notice on its website reading substantially as follows: AA fast-growing Orange County company is offering to sell its common stock to qualified California residents.@ The posting also lists the name and telephone number of the Hough employee primarily responsible for the offering. Hough=s notice is available by hyperlink on Baker=s website. Hough simultaneously sends copies of the offering circular prepared by Baker to its customers with California addresses, as reflected in Hough=s customer records. One of the customers so solicited is Gomez, whose business is in Temple City, California, but who now spends about 4 months a year in Temple City and the remainder of the year in Scottsdale, Arizona. Gomez grew up in Temple City. He bought his current residence in that city 30 years ago and resided there exclusively until he learned to play golf. Since that time, he has spent the majority of his time in Scottsdale, living in a Agolf course villa@ which he owns, but conducting no business there. The offering is successful and is fully subscribed and sold by September 12, 2003. Of the 45 persons expressing an interest in the offering, 20 persons, all of whom are California residents, purchase stock. Baker places no restrictions of any kind on the shares sold in the offering. On September 15, 2003, Baker closes the Russell acquisition. In September 2004, Adams, who is an officer and the largest shareholder of Baker, owning in excess of 20% of the outstanding Baker common stock, decides to sell some of her stock. (Adams originally bought half of her stock in a private placement by Baker about 10 years ago. The other half of her stock was bought at about the same time in a private transaction from the estate of Basgall, one of the founders of the company.) Adams approaches Welch, a banker in the Los Angeles area, and offers to sell 25% of her stock (i.e., 5% of Baker=s outstanding stock) in a private transaction. Welch, whose net worth exceeds $2 million, is not experienced in the household goods industry, but has a wealth of experience in financial matters generally. Adams supplies extensive amounts of financial information concerning Baker to Welch, who spends three days in Baker=s offices reviewing files and talking to executives. On September 15, 2004 Adams sells the shares to Welch. In October 2004, Adams sells one/third of her remaining Baker shares (i.e., 5% of Baker=s outstanding stock) in a series of market transactions through Hough, a registered securities broker. Hough executes such trades upon receiving orders from purchasers of the stock and does not solicit such orders. Determine the application of the =33 Act to the events described above. Please discuss. (In all cases, assume that the Ainterstate commerce/mails@ jurisdictional means have been used.) Page 8 of 9
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