Securities Regulation

Securities Regulation

Professor Bradford

Spring 2004

Exam Answer Outline

The following answer outlines are not intended to be model answers, nor are they intended to include every issue students discussed. They merely attempt to identify the major issues in each question and some of the problems or questions arising under each issue. They should provide a pretty good idea of the kinds of things I was looking for. If you have any questions about the exam or your performance on the exam, feel free to contact me to talk about it.

I graded each question separately. Those grades appear on the front cover of your blue books. To determine your overall average, each question was then weighted in accordance with the time allocated to that question. The following distribution will give you some idea how you did in comparison to the rest of the class:

Question 1: Range 4-9; Average 6.25

Question 2: Range 4-9; Average 6.95

Question 3: Range 4-9; Average 6.60

Question 4: Range 3-9; Average 6.60

Question 5: Range 5-8; Average 6.50

Total (of exam, not final grades): Range 4.71-8.21; Average 6.65

Question 1

Section 12(a)(1) of the Securities Act makes anyone “who offers or sells a security in violation of section 5” liable to the person purchasing from him for the purchase price, or damages if the purchaser has already sold the security. Two questions arise in determining Stud’s liability under § 12(a)(1): (1) Is Stud a “seller” within the meaning of Pinter v. Dahl; and (2) Has Stud violated § 5 and, if so, as to which purchasers?

1. Is Stud a “seller”?

Stud is not a seller to these purchasers in the title-passing sense. Stud’s clients purchased on the open market, with Stud serving as broker. The title-passing seller is whoever was on the other side of the market transaction.

However, Stud is a “seller” within the meaning of Pinter v. Dahl. He solicited these clients for value. The phone calls and e-mails urging the clients to buy the Cather stock were clearly offers within the meaning of § 2(a)(3). And he engaged in the solicitation to serve his own financial interests—to obtain commissions.

As Stud is a seller, he is liable to anyone he offered or sold to in violation of § 5.

2. Did Stud violate § 5?

a. The telephone calls

The telephone calls on February 15, and later on March 24, do not violate § 5. They are offers to sell, § 2(a)(3), which § 5(c) prohibits, but § 5(c) only applies “unless a registration statement has been filed.” As Cather’s registration statement had already been filed, § 5(c) does not apply. They also do not violate § 5(b)(1) because they do not constitute a “prospectus.” A prospectus must be “written or by radio or television”, so phone calls are not included. They also do not violate § 5(a) because there has been no “sale.” Sale means a completed contract, § 2(a)(3), not merely an offer.

b. The March 24 e-mails

The e-mail on March 24 does violate § 5(b)(1). The SEC takes the position that e-mail is equivalent to a writing. Since the e-mails solicited the recipients to buy Cather stock, they are an offer to sell, and therefore a “prospectus.” § 2(a)(10). They do not fall within the exception in § 2(a)(10)(a) because the e-mails, although sent after the effective date, were not accompanied or preceded by a written prospectus meeting the requirements of § 10(a), the final prospectus. They do not fall within the exception in § 2(a)(10)(b), as extended by Rule 134, because they do not include the legend required by Rule 134(b) and the sales pitch is not allowed by Rule 134(a). They are not within Rule 134(c) because they include more than just the information allowed by Rule 134(c)(i) and they do not fall within Rule 134(d) because they don’t include the legend and weren’t accompanied or preceded by a section 10 prospectus. They clearly do not meet the requirements of § 10, so they violate § 5(b)(1).

Stud had no exemption that would excuse him from complying with section 5. He doesn’t fit within § 4(1) because he is a dealer. See § 2(a)(12). Section 4(2) doesn’t apply because he’s not the issuer, and § 4(4) doesn’t apply because, although he is a broker, he did solicit these transactions. Section 4(3) doesn’t help because, although he clearly is a dealer, these calls occurred less than 40 days after the effective date. Rule 174(d) applies to shorten the required period to 25 days because Cather is traded on NASDAQ, “an electronic inter-dealer quotation system sponsored and governed by the rules of a registered securities association.” However, these e-mails were within 25 days of the effective date.

Therefore, any purchaser who received the March 24 e-mails has a cause of action under Section 12(a)(1). The violation does not have to have anything to do with the customer’s loss, so it doesn’t matter that the loss was caused by a general market downturn.

c. The March 27 confirmations

As to the other purchasers, the mailing of the confirmations on March 27, although sent without a prospectus, is not a violation. Section 5(b)(1) makes it unlawful to transmit a prospectus not meeting the requirements of § 10. A writing confirming the sale of any security is a prospectus, § 2(a)(10) and the SEC treats an e-mail as a writing. The § 2(a)(10)(a) free-writing exception does not apply because no final prospectus was ever sent, and the § 2(a)(10)(b) exception does not apply because a confirmation contains information not allowed by subsection (b) or Rule 134. Thus, this appears to be a violation of § 5(b)(1).

However, Stud has the § 4(3) exemption. Stud was not a participant in the offering, so he has no unsold allotment and the confirmation is mailed more than 25 days after the effective date, which, as mentioned above, Rule 174(d) modifies § 4(3) to impose. Therefore, the March 27 e-mails are exempted from § 5. Only the people who received the e-mails on March 24 have a § 12(a)(1) cause of action against Stud.

Question 2

a. TSC says the question is whether there’s a substantial likelihood a reasonable investor would view the misstatement or omission as significantly altering the “total mix” of information mad available. If the truth is already publicly known through the 10-K and the annual report, the market price should adjust to reflect the truth and the misstatement should not significantly alter the total mix of information. This is the Wielgos truth-on-the-market idea. However, not every court has accepted the idea that a fraud in one document can be cured by the truth in another document. See United Paperworkers International Union v. International Paper Co.

b. This could affect materiality. A reasonable investor is more likely to consider important a statement in a financial source directed at investors than a statement in an advertisement in a sports magazine. Investors probably expect more puffery in product advertisements, and this could affect materiality. See Eisenstadt v. Centel Corp. In addition, reasonable investors are probably less likely to rely on ads in general and on the contents of a sports magazine.

c. This has nothing to do with materiality. A false statement may be made innocently, and nevertheless be important enough to be material. The speaker’s knowledge concerns only scienter, not materiality.

Question 3

All sales of securities, including resales, must comply with the requirements of § 5 of the Securities Act, unless there is an exemption. Sam did not register the stock he resold, so he violated § 5 unless he had an exemption.

The usual statutory exemption for resales is § 4(1) for “transactions by any person other than an issuer, underwriter, or dealer.” Sam is not the issuer of this common stock; Acme is. Sam is also not a securities dealer; he is an attorney. See § 2(a)(12). Thus, § 4(1) provides an exemption to Sam unless Sam is an underwriter.

Is Sam an Underwriter?

An underwriter is, among other things, anyone who purchases from an issuer with a view to the distribution of any security. § 2(a)(11). For purposes of this portion of the definition, a resale is a “distribution” if it violates the issuer’s original exemption. Acme used the Rule 506 exemption to sell to Sam. The sale to Barbara is not consistent with the Rule 506 exemption. Barbara is not an accredited investor, and Rule 506 purchasers who are not accredited investors must meet a sophistication standard. Rule 506(b)(2)(ii). Therefore, Sam’s resale to Barbara is a distribution for purposes of § 4(1) and Sam is an underwriter if he purchased from Acme “with a view to” that distribution.

The “with a view to” requirement asks whether, when Sam bought the stock from Acme, Sam had investment intent or an intent to resell. The usual way to show investment intent, and avoid being an underwriter, is a sufficiently lengthy holding period. Usually, the presumption turns in Sam’s favor after two years. However, that common law presumption was established when the Rule 144 holding period was two years; now that the Rule 144 holding period is only one year, perhaps the common law standard will change to reflect that. It hasn’t yet.

One difficulty here is determining Sam’s holding period. Do we measure from the time he entered into the contract with Barbara or from the time Barbara completed her installment payments and Sam’s security interest expired? There is no clear answer to this, which may mean that Sam has not met his burden of establishing the exemption. In another context, for purposes of § 3(a)(11), the SEC staff took the position that the sale was not complete until the final installment payment was made. However, they indicated that the result might be different if a promissory note was given. It’s unclear here if Barbara gave Sam a negotiable promissory note or just made a contractual promise to pay. If the sale does not occur until April 1, 2004, Sam may have established investment intent, so he has the § 4(1) exemption and has not violated the Securities Act. If the sale occurs on May 1, 2003, Sam probably has not established investment intent, so he does not have the § 4(1) exemption and has violated the Securities Act.

Rule 144

There are two safe harbors for resales, Rule 144A and Rule 144. Rule 144A is not helpful because Sam has not sold to a qualified institutional buyer, as required by Rule 144A(d)(1). Barbara is not an institution. See Rule 144A(a)(1).

Rule 144 might be available. It says that anyone who sells restricted securities for his own account is not an underwriter, if all the conditions of the rule are met. Rule 144(b). Securities sold pursuant to Rule 506 are “restricted securities.” Rule 144(a)(3)(ii). As an Exchange Act reporting company, Acme meets the current public information requirement of Rule 144(c)(1) if all its reports are current. Whether we treat the original contract or the final installment as the “sale” for purposes of Rule 144, the one-year holding period of Rule 144(d)(1) is met.

Sam does not meet the limitation on sales amount in Rule 144(e). Rule 144(e)(2) applies since Sam is not an affiliate. It says that all of the restricted securities Sam sells must not exceed the limits in Rule 144(e)(1). Those limits are the greater of 1% of the shares outstanding, Rule 144(e)(1)(i), or the average weekly trading volume, Rule 144(e)(1)(ii),(iii). Sam sold 70,000 shares, which is greater than both 1% of the shares outstanding (1.5 million x .01 = 15,000) and the average weekly trading volume of 50,000. Sam also does not meet the requirement in Rule 144(f), because he sold his shares directly to Barbara without any assistance; it was not a broker’s transaction.

Sam’s only hope is Rule 144(k). It excuses a non-affiliate such as Sam from all the conditions of Rule 144 if two years have elapsed since the shares were acquired from Acme. Unfortunately, that leaves us with the same question we faced under § 4(1): when did Sam’s sale to Barbara occur? Rule 144 does not directly answer that question, but it does provide some additional help. Rule 144(d)(2) says that a seller does not acquire the securities pursuant to an installment plan until the full price is paid, unless the obligation provides for full recourse against the person, is secured by collateral other than the securities purchased, and is discharged by full payment before the person resells the securities. Although this provision deals with when Sam, the Rule 144 seller, acquired the securities from the issuer, presumably the same rules should be used to determine when Barbara acquired the securities from Sam. Barbara does not meet all three requirements of Rule 144(d)(2), because the only collateral she gave was the stock itself, and Rule 144(d)(2)(ii) requires collateral other than the stock. Therefore, by analogy to Rule 144(d)(2), the sale occurred only when Barbara made the final installment payment, on April 1, 2004. That is more than two years after Sam purchased from the issuer, so Rule 144(k) applies. Sam’s resale comes within Rule 144, and it does not violate the Securities Act.

Question 4

a. Section 3(a)(11): The entire issue must be offered and sold only to persons residing in a single state. § 3(a)(11). Even though the securities were sold only to Rhode Island residents, the offerees reside in several different states.

b. Rule 505: The maximum aggregate offering price for a Rule 505 offering is $5 million, less the price of all other securities sold within the past 12 months pursuant to a § 3(b) exemption. Rule 505(b)(2)(i). Regulation A is a § 3(b) exemption and the earlier offering was within 12 months of April 1, so the maximum offering price under Rule 505 is $1 million, which the $2 million offering exceeds.

c. Section 4(2): The securities may be offered and sold only to investors who, because of their sophistication, expertise, and access to information, can fend for themselves. Ralston Purina. The five unsophisticated purchasers do not meet this requirement (and possibly some of the offerees who did not purchase as well).