15

Securities Regulation

Professor Bradford

Spring 2017

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 good idea of the kinds of things I was looking for. In some cases, the result is unclear; the position taken by the answer outline is not necessarily the only justifiable conclusion.

I graded each question separately. Those grades appear on your printed exam. 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 3-9; Average = 5.95

Question 2: Range 3-9; Average = 4.95

Question 3: Range 3-9; Average = 6.00

Question 4: Range 0-8; Average = 4.11

Question 5: Range 4-8; Average = 6.42

Question 6: Range 0-8; Average = 4.79

Question 7: Range 3-8; Average = 6.00

Total (of unadjusted exam scores, not final grades): Range 3.68-7.83; Average = 5.43

All of these grades are on the usual law school scale, with 9 being an A+ and 0 being an F.

If you have any questions about the exam or your performance on the exam, feel free to contact me to talk about it.

Question 1

The maximum amount Delta could raise in the current, Rule 504 offering is $1 million.

Rule 504(b)(2), as corrected by the SEC, says the offering amount in a Rule 504 offering shall not exceed $5 million, “less the aggregate offering price for all securities sold within the twelve months before the start of and during the offering of securities under this Rule 504 or in violation of section 5(a) of the Securities Act.”

The prior offering, purportedly under Regulation A, was in violation of section 5 because it was not in compliance with Regulation A. Rule 251(d) prohibits offers in an Regulation A offering prior to the filing of the offering statement, except as allowed by Rule 255. Broker solicited its customers prior to that filing and the question says those solicitations did not comply with Rule 255. Thus, Delta did not comply with 251(d)(1)(i). The exemption is not protected by Rule 260’s substantial compliance rule because the failure to comply must be insignificant with respect to the offering as a whole and violations of 251(d)(1) are deemed significant to the offering as a whole. Rule 260(a)(2).

Integration is not a problem because Rule 502(a) protects the current Rule 504 offering from integration since the Regulation A offering was more than six months prior, but the reduction of the offering amount under 504(b)(2) does not depend on integration.

Question 2

No General Duty to Disclose

Sonsing has no general duty to disclose all material information under Rule 10b-5. See Basic, fn. 17. Therefore, Sonsing is not liable merely because it did not initially provide the information about the technical problems and the consumer surveys. It must have made a materially misleading statement.

Omnicare and Expressions of Opinion

Where, as here, a statement is expressed as an opinion (“we believe”), the person making the statement can be liable in two circumstances: (1) if the person making the statement did not believe it and it was objectively false; or (2) if the statement omits material information that would result in the opinion materially misleading investors. Omnicare. The question indicates that Sonsing’s officers and directors honestly believed what they said. Thus, Sonsing is liable only if the opinions expressed in the press release were materially misleading because of the omission of the additional information.

Materiality

An omitted fact is material there is a substantial likelihood that a reasonable investor would consider it important. TSC Industries.

Omnicare makes it clear that not every omission of facts contrary to an opinion render the opinion materially misleading. Investors realize when an opinion is expressed that not all the facts the speaker is aware of may be consistent with that opinion. But, if the facts go to the basis of the opinion and would mislead investors if not disclosed (which Omnicare says is a difficult case to make), the omission can violate Rule 10b-5.

Here, the two facts omitted go directly to the heart of Sonsing’s claim. The failure rate is inconsistent with the claim of the best technical quality and the consumer testing is inconsistent with the claim of the best picture. However, many consumers in the testing actually did prefer the new phone’s pictures, and investors undoubtedly realize that picture quality is partially an aesthetic judgment as to which people will differ. Because of that, the fact that many people disagree with the company’s claim about picture quality may not be material. The other omission is more difficult; if the phone, in Sonsing’s own testing, is 10 times more likely to fail, that’s significant in relation to the claim of “best technical quality,” especially if there’s no other evidence that support’s Sonsing’s claim.

There is one other consideration in determining materiality. This is a seller’s claim about the quality of its product—essentially, advertising, even though it’s in a press release. People expect some puffery in such statements, and where puffery is expected, misleading statements are less likely to be material. Eisenstadt.

Loss Causation

To be actionable, the false statement must be the proximate cause of the investors’ losses. In particular, the price of the security must fall after the truth became known. Dura Pharmaceuticals. Here, the price did not drop after Sonsing’s subsequent disclosure of the omissions.

However, the phone was released ten days before Sonsing’s corrective disclosure. Consumers and investors could see the picture quality themselves and consumers directly experienced the technical problems with the phone. Because of that, the truth arguably became known before the April 10 release and the price drop between April 1 and April 10 is arguably due to correction of the fraud. However, the burden is on the plaintiffs to show loss causation, so they have to prove that.

“In Connection With”

To be actionable under Rule 10b-5, the false statement must be in connection with the purchase or sale of a security. The statement was in a press release arguably directed at consumers, not in anything directly specifically at investors. However, it’s enough that the statement is reasonably calculated to influence the investing public, and the press release is a medium on which investors usually rely, so this statement was probably in connection with the plaintiffs’ purchases of Sonsing’s securities.

Safe Harbor for Forward-Looking Information

Finally, Sonsing appears to be trying to use the statutory safe harbor for forward-looking information to protect the statements in the press release. See Exchange Act § 21E. The release indicates that it contains forward-looking statements and there are specific cautions as to why actual results could differ. If it is a forward-looking statement and Sonsing meets the requirements of subsection (c)(1)(A)(i), then Sonsing would be protected from liability for damages in this private action. However, the safe harbor doesn’t apply because this simply is not a forward-looking statement as defined in § 21E(i)(1). This is a statement of present fact about the current quality of an existing phone, so the safe harbor is irrelevant.

Question 3

A. This would preclude Beta from using the exemption. The exemption is not available to any issuer that is subject to the Exchange Act reporting requirements. Rule 100(b)(2).

B. Beta could use the exemption. It’s within the $1 million limit in Rule 100(a)(1) and nothing in the exemption precludes its use for bonds. Rule 100(a) just says “securities.”

C. Smith would fall within the purchaser limits of Rule 100(a)(2)(i) because both his annual income and his net worth are less than $100,000. (Subsection (i) applies if either is less than $100,000.) Smith may invest the greater of $2,000 or 5% of the lesser of net worth or income. Rule 100(a)(2)(i). He is only investing $2,000, so he is in compliance.

D. Jones falls within Rule 100(a)(2)(ii) because both his annual income and his net worth are equal to or more than $100,000. His limit is 10% of the lesser of net worth or annual income, which would be $2 million, but that is subject to a maximum “not to exceed an amount sold of $100,000.” Thus, it would violate the rule if Beta allowed him to invest $200,000.

E. This would not preclude Beta from using the exemption. The aggregate amount sold in 12 months “in reliance on section 4(a)(6)” may not exceed $1 million. Rule 100(a)(1). The prior sales were not in reliance on section 4(a)(6). Amounts sold pursuant to other exemptions do not need to be subtracted from the $1 million limit. Integration is also not a problem. It’s not in the rule, but the SEC made it clear in the release that Regulation Crowdfunding offerings will not be integrated with other offerings.

F. This is acceptable under Rule 204, which excludes certain notices from the general prohibition in Rule 204(a) against advertising the offering. Rule 204(b)(1) says the issuer may indicate that it is doing a section 4(a)(6) offering and may name the intermediary. Rule 204(b)(2) allows the notice to include the terms of the offering, which the Rule 204 instructions define to include the amount of securities offered and the price, the nature of the securities, and the closing date. Rule 204(b)(3) allows the notice to include all of the identifying information about the company that this notice contains.

Question 4

Section 5(c) of the Securities Act makes it unlawful to offer a security unless a registration statement has been filed and section 5(a)(1) makes it unlawful to sell a security unless a registration statement is in effect. These prohibitions are not limited to issuers, so Smith’s unregistered sales violate the Act unless an exemption was available.

Section 4(1½)

“Section 4(1½)” is not a separate exemption, but a label for the usual statutory exemption for resale, section 4(a)(1). Section 4(a)(1) exempts “transactions by any person other than an issuer, underwriter, or dealer.” Smith is neither an issuer nor an underwriter. Broker is a dealer but, if it is only a dealer, the 4(a)(3) exemption would be available for it because the 40/90 day time period has long passed.

However, Broker might be an underwriter. The term “underwriter” includes anyone who “offers or sells for an issuer in connection with, the distribution of any security.” Section 2(a)(11). Issuer, for these purposes, is defined to include “any person directly or indirectly controlling . . . the issuer.” Smith, as Gamma’s CEO, would definitely be a control person of Gamma. See the definition of “control” in Rule 405. Broker is selling for Smith.

The key is whether the resale constitutes a distribution. For purposes of resales by an affiliate such as Smith, distribution is usually defined similarly to the term “public offering” in section 4(a)(2). Under Ralston Purina, the question is whether the offerees can fend for themselves. The purchasers appear to be sophisticated investors and can probably fend for themselves, but section 4(a)(2) focuses on the offerees, and this offering was also made to unsophisticated, unaccredited investors. However, there’s not an exact equivalence between the two, so perhaps it’s sufficient that all of the purchasers can fend for themselves.

Rule 144A

Rule 144A, a safe harbor for section 4(a)(1) is not available. To qualify under 144A, the securities must be sold only to qualified institutional buyers. Rule 144A(d)(1). All of the purchasers own sufficient securities to qualify under Rule 144A(a)(1)(i), but the two individual investors are not institutions, so they don’t qualify under any parts of the definition in 144A(a)(1).

Rule 144

Rule 144, another section 4(a)(1) safe harbor, is not available. Smith is an affiliate within the meaning of 144(a)(1) because, as CEO, he controls the issuer, Gamma. Therefore, his transaction falls within 144(b)(2) and he must comply with all of the conditions of Rule 144. Under 144(f)(1), the securities must be sold in brokers’ transactions (except for some other possibilities not applicable here). These sales do not qualify as brokers’ transactions because Broker actively solicited 200 of its customers. See Rule 144(g)(3). It’s highly unlikely that all of these customers asked Broker about Gamma securities in the last ten business days. See Rule 144(g)(3)(ii).

Section 4(a)(7)

Section 4(a)(7) appears to be available. To qualify for exemption, the resale transaction must meet the requirements of section 4(d). Each purchaser appears to be an accredited investor—the individuals under Rule 501(a)(5) and the institutions under 501(a)(3). Thus, the requirement of (d)(1) is met. There was no general solicitation or advertising, something prohibited by (d)(2). Broker solicited its customers, but Broker had a preexisting relationship with them. Under SEC staff’s interpretations, that would not be a general solicitation. Gamma is a reporting company, so (d)(3) does not apply. This security has been authorized and outstanding for at least three years, so (d)(8) is satisfied. The only potential problem would be if the issuer fell within the bad actor prohibition of (d)(5) or was a company prohibited from using the rule by (d)(6). We don’t have sufficient facts to answer that question.