CHAPTER 24 CHAPTER 24 Public and Private Offerings of Securities

INTRODUCTION This chapter explores security regulations, registration and reporting requirements, and violations of the requirements. 2

FEDERAL STATUTORY SCHEME  1933 Act.  Covers original distribution of securities.  Requires promoters to register securities with the SEC, and a prospectus to be given to prospective purchasers.  Investors are not protected from highly speculative investments—only advised of all material facts.  1934 Act.  Builds upon 1933 Act with continuous disclosure for publicly traded securities.  Contains the first anti-fraud provisions.  Requires regular reporting to SEC. 3

 Private Securities Litigation Reform Act of – Designed to correct perceived abuses in private securities litigation, particularly in class actions that coerced settlements thereby increasing the costs raising capital and correct the chilling of corporate disclosures to investors. – Limited “fishing expeditions” during discovery. – Generally eliminates joint and several liability.  SEC Rules and Regulations.  Blue Sky Laws – state regulatory statues. 4 FEDERAL STATUTORY SCHEME

DEFINITION OF TERMS  Security - very broad definition; not just stocks, bonds and investment contracts; but not real estate. – Investment Contract: investment of money in common enterprise with profits to come solely form the efforts of others. – Family Resemblance Test - promissory notes may be a security, depending on the circumstances. 5

 Offer - the 1933 Act definition is “every attempt to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” Much broader than contract law.  Sale - “every contract for sale or its disposition of a security or interest in a security, for value” (cash, property or compensation for past services). DEFINITION OF TERMS

7 INVESTMENT CONTRACT Case 24.1 Synopsis. SEC v. W. J. Howey Co. Howey owned large tracts of citrus groves in Florida, financed in part by the sale of strips of land containing citrus trees to people throughout the United States. Along with the sale of the land came an optional service contract to care for the trees and fruit. ISSUE: Does the offer and sale of parcels of land bearing citrus trees, coupled with optional management contracts pursuant to which the promoter cares for the trees, constitute an investment contract and hence a security under Section 2(1) of the 1933 Act? HELD: YES. The Supreme Court held that this transaction clearly was an investment contract (a security) because the person invested money in a common enterprise and expected profits solely from the efforts of the promoter or third party.

8 FAMILY RESEMBLANCE TEST Case 24.2 Synopsis. Reves v. Ernst & Young A farmers’ co-op with about 23,000 members raised money to support its general business operations by selling demand notes. The notes were not collateralized and were uninsured, and paid a variable interest rate that was higher than financial institutions. The co-op offered these notes to members and non-members of the co-op as an investment program. ISSUE: Are demand notes issued by a farmers’ cooperative to its members securities? HELD:Yes. The Supreme Court ruled that these demand notes were securities.

9 PUBLIC OFFERING Assuming investment is a security, it must be registered.  Registration of Securities - Section 5 of the 1933 Act requires registration of all securities with SEC offered and sold in the United States unless exempt.

 Role of the Underwriter - public offerings usually underwritten by one or more broker-dealer(s) or investment banker(s). – Firm Commitment Underwriting - underwriter buys the entire offering and re-sells. – Best-Efforts Underwriting - underwriters do not buy the offering, but use their best efforts to find buyers. PUBLIC OFFERING

11  The Registration Statement - Sections 7 and 10 contain the guidelines. – Forms - initial public offerings use Form S-1; Form S-2 allows previous filers a streamlined form and a way to incorporate previous filings by reference; Form S-3 is for previous filers with a widespread following in the marketplace; the SEC also has adopted two forms for small business (SB-1 and SB-2). PUBLIC OFFERING

 Prospectus - disclosure and marketing tool to prospective purchasers.  Due Diligence - company has to be able to back up every claim in the registration statement. PUBLIC OFFERING

13 PUBLIC OFFERING

14  Registration Procedure - Section 8 of the 1933 act provides registration automatically becomes effective on the 20th day after filing; each amendment starts a new 20-day period. PUBLIC OFFERING

 Review - first time registrants receive a complete SEC review. Comments from SEC in a Letter of Comment.  Waiting Period (or quiet period) - the time between the filing of the registration statement and its becoming effective. “Red Herring” preliminary prospectus.  Going Effective - once an offering is declared effective, sales of securities may be made. PUBLIC OFFERING

16 PUBLIC OFFERING

17  Shelf Registration - Rule 415 of the 1933 act allows registration of a number of shares at one time for later issuance.  Reorganizations and Combinations - certain types fall under Rule 145 and are filed on Form S-4.  Secondary Offerings - subsequent offering by a person other than the issuer; must be registered with the SEC or be exempt. PUBLIC OFFERING

18 Difference between exempt securities (such as federal and state issues) and exempt transactions (such as private offerings).  Private Offerings - non-public offering to selected qualified investors. EXEMPTIONS FOR OFFERINGS BY THE ISSUER

 Regulation D: Safe-Harbor Exemptions for Private Offerings. – Accredited Investors - Rule 501 exempts sophisticated investors. – Integration of Sales - successive sales within a limited time period. – Rule offerings of up to one million dollars within twelve months to an unlimited number of purchasers. – Rule offerings up to five million dollars within twelve months to 35 or fewer unaccredited investors. – Rule offerings to no more than 35 unaccredited investors and an unlimited number of accredited investors. EXEMPTIONS FOR OFFERINGS BY THE ISSUER

Case 24.3 Synopsis. SEC v. Ralston Purina Co. Ralston Purina offered stock for market prices to its employees, regardless of job classification. Between 1947 and 1951 Ralston Purina sold $2 million worth of stock to 2,000 employees throughout the United States. ISSUE: Does the determination of whether a transaction is public or private offering depend primarily on the number of offerees or the sophistication of the offerees? HELD: NO. The Supreme Court ruled that these sales were not exempt from registration as a private sale. It is not merely numbers of employees, but the sophistication of them due to access to information. EXEMPTIONS FOR OFFERINGS BY THE ISSUER

 Section 4(6) Exemption - from the 1933 act - like Regulation D requirements.  Regulation A - “testing the waters” provisions which permits issuers to solicit indications of interest before filing. – Size of Offering and Eligible Companies. – Testing the Waters - checking interest in the proposed offering pre-offer. EXEMPTIONS FOR OFFERINGS BY THE ISSUER

 Offerings to Employees - Rule 701 exemption of certain offers and sales of securities.  The Private Placement Memorandum - private offering counterpart to the prospectus. Both selling and disclosure document. EXEMPTIONS FOR OFFERINGS BY THE ISSUER

23 EXEMPTIONS FOR SECONDARY OFFERINGS  Section 4(1) Exemption Act; secondary offerings are exempt.  Rule criteria deciding if someone is an underwriter

24 RULE 144A AND REG S  Rule 144A - permits resale of unregistered securities to qualified institutional buyers, i.e., institutional investors holding and managing $100 million or more of securities, if the securities are not of the same class as any listed securities.  Regulation S - offers and sales must be made offshore so they are not subject to U.S. federal registration requirements.

25 VIEW FROM CYBERSPACE: OFFERINGS ON THE INTERNET  SEC’s position is that offerings on the net violate the general solicitation ban unless the offering materials are restricted to pre-qualified investors, usually only done by password protected files after completing of a questionnaire. NETROADSHOW.COM.  SEC has ruled that any hyper-linked information contained in an on-line prospectus becomes part of the prospectus itself.

26 REPORTING REQUIREMENTS OF PUBLIC COMPANIES  Section 12 - issuers in interstate commerce and having total assets exceeding $5 million must register with the SEC each non-exempt class of security that is listed on a national exchange or is an equity security held by at least 500 persons.

 Other Sections of the 1934 Act. – Proxy Solicitations - Section 14. – Insider Trading - must disclose securities holdings of officers, directors, and 10% or more shareholders of the issuer’s equity securities and any changes in the holdings. – Tender Offers - Section 14 rules. – Schedule 13D - acquirers of 5% or more of shares must file one within ten days of acquisition. REPORTING REQUIREMENTS OF PUBLIC COMPANIES

28 SELECTIVE DISCLOSURE AND REGULATION FD (FAIR DISCLOSURE) In October, 2000, SEC adopted prohibition of selective disclosure of material information to analysts before making it available to the general public

29 VIOLATION OF THE REGISTRATION AND PROSPECTUS-DELIVERY REQUIREMENTS OF THE 1933 ACT: SECTION 12(1)  Elements of Liability - strict liability for sale or offered securities without effective registration statement, or non-complying prospectus, through the use of interstate transportation or communication.  Damages - if the plaintiff has not sold - rescind the sale; if sold - damages.  Who May Be Sued - definitely the insurer.  Who May Sue - anyone who purchased shares issued in violation of the registration requirements

30 Case 24.4 Synopsis. Pinter v. Dahl (1988). Dahl purchased unregistered securities in the form of oil and gas interests from Pinter, an oil and gas producer and registered securities dealer in Texas. Dahl got his friends and family to also purchase securities from Pinter. When the investment failed, they all sued Pinter for a violation of Section 12(1) of the 1933 Act. Pinter claimed Dahl was a seller under Section 12(1) because he substantially encouraged his friends and family to purchase the shares. ISSUE: Is a person with no financial interests in an offering of unregistered securities a seller under Section 12(1) of the 1933 Act? HELD: The Supreme Court remanded the case to determine if Dahl made the recommendations to further a goal of Dahl or Pinter, or for the benefit of the friends and family who were the buyers. The Court said that Congress did not intend to impose liability on one who gave advice solely for the benefit of the buyer. VIOLATION OF THE REGISTRATION AND PROSPECTUS-DELIVERY REQUIREMENTS OF THE 1933 ACT: SECTION 12(1)

SECTION 11 OF THE 1933 ACT Sale pursuant to a misleading registration statement.  Who May Sue - anyone who acquired a registered security. – Tracing Requirements - tie purchase to misleading statement. – Class Actions - typically done.

 Who May Be Sued - Section 11 lists who may be sued. – Controlling Persons - Section 15 imposes liability on anyone who controls any person under Section 11 or 12; “control” is not defined in the 1933 Act.  Elements of Liability - plaintiff must show when the registration statement became effective it contained a false or misleading statement concerning a material term. SECTION 11 OF THE 1933 ACT

33  Defenses – No Reliance - investor knew of misstatement or omission. – No Causation - plaintiff suffered no loss. – Due Diligence - defendant conducted a reasonable investigation and it reasonably believed the statements made were true and there were no omissions which made the statements misleading. SECTION 11 OF THE 1933 ACT

 Bespeaks Caution Doctrine - can negate misrepresentations and omissions in prospectus.  Reform Act Safe Harbor for Forward- Looking Statements.  Damages - for sale and no sale of the securities. SECTION 11 OF THE 1933 ACT

35 DUE DILIGENCE Case 24.5 Synopsis. Escott v. BarChris Construction Corp. ( 1968). BarChris built bowling alleys with capital raised through public offerings. It obtained money in May 1961, but due to financial problems, filed for bankruptcy protection in October of A class action suit was filed alleging Section 11 claims against the company, its officers and directors, and underwriters. The court found that only the outside directors could rely on the due diligence defense because of their knowledge of the company. The defendants were held liable for misleading statements on the registration statements.

36 SECTION 12(2) OF THE 1933 ACT  Remedy for purchaser of any security by means of a misleading prospectus or oral communication.  Who May Be Sued - anyone who offers or sells a security by means of a misleading prospectus.  Reasonable Care Defense - defendant is not liable if the defendant can show he or she did not know and could not have known (using due care) about the misrepresentation and omissions.

Case 24.6 Synopsis. Gustafson v. Alloyd Co. Three individuals own all the stock in Alloyd, a manufacturing corporation. They all agreed to enter a stock purchase agreement to sell their shares to Wind Point, an investment partnership. The individuals made a misrepresentation about the value of the company based on the inventory and financial statements. SECTION 12(2) OF THE 1933 ACT

When a year-end audit disclosed this difference, Wind Point sued, alleging a material misrepresentation in the purchase agreement, which Wind Point characterized as a prospectus. ISSUE: Does Section 12(2) apply to misrepresentations in a stock-purchase agreement in connection with a private offering of stock? HELD: The Supreme Court ruled that Section 12(2) does not apply to private offerings as here, but only to public offerings. Wind Point’s claim was dismissed. SECTION 12(2) OF THE 1933 ACT

39 LIABILITY OF CONTROLLING PERSONS  Courts do not agree: – Some courts hold that liability attaches when defendant had power to control the general affairs of the company. – Other courts require participation in the securities violation.  Controlling person is officer, director or major shareholder of the company.  Section 15: No strict liability: knowledge required.

40 CRIMINAL PENALTIES Not more than $10,000 fine and/or five years in prison.

41 THE RESPONSIBLE MANAGER Complying with Registration Requirements Any person offering securities must comply with the registration requirements of the 1933 Act as well as any applicable blue sky laws. This includes start-up companies, as well as large, publicly traded companies. Failure to comply gives the purchaser of the security the right to keep the proceeds if the investment is successful or to return the security to the seller if the investment does not turn out as hoped.

42 REVIEW 1. Why do states need blue sky laws? 2. Are securities laws pro-active or reactive? Why? 3. Why is the securities area so highly regulated? 4. Should there be special rules for sale of stocks on the internet?